Addressing Financial Reporting Complexity

As this is my first column for Compliance Week, I’ve decided to go slowly, and start with a light, non-controversial topic: complexity in financial reporting.

Just kidding—I actually can’t think of a more contentious or divisive topic.

In fact, it seems like everybody is talking about complexity in our financial reporting and standard setting—it’s a topic now ubiquitous in accounting journals, corporate boardrooms, op-ed pages, and regulatory roundtables.

The question, of course, is this: When will we stop talking about it, and start doing something about it?

Unfortunately, action isn’t that easy.

Last October, when I was president of Financial Executives International, we convened a diverse group of financial-reporting constituents—including representatives from large accounting firms, the standards setters, the American Institute of Certified Public Accountants, the CFA Institute, the National Investor Relations Institute, and various other financial-statement users—to discuss the issue of complexity in financial reporting.

It became apparent very quickly that we all viewed the “problem” very differently.

The Many Faces Of “Complexity”

To financial-statement users, complexity exists when there are divergent standards—or application thereof—that inhibit the users’ ability to compare one company to another. Similarly, complexity comes from prospective application, and long transition periods of new standards—how can the financial-statement users easily compare data year over year? Remember, most financial-statement users read the financial statements, not the accounting standards—to them, the complexity resides in the company filings, not in a particular standard as promulgated by the Financial Accounting Standards Board.

To the financial-statement preparers and auditors, however, complexity comes in the actual implementation and audit of those accounting standards. A seemingly simple standard that says, for example, “record all contingent liabilities at fair value,” would be immensely complicated to implement. Myriad judgments and estimates come into play, and subject matter experts become essential. That’s especially the case with standards such as FAS 133, which regards accounting for derivative instruments, as independence rules and practical sensitivities have made it difficult to rely on known and trusted experts—the company’s outside auditor—for advice.

Even the largest global enterprises, which staff the best and brightest accounting minds, have difficulty applying these complex standards—several large multinationals have had more than one restatement attempting to comply. Imagine the difficulty that mid-sized and smaller companies must have when addressing those same issues.

But even another type of complexity exists: that which is applicable to the regulators and standard setters. To those agencies, complexity is created by the constituents who regularly ask for exceptions, “bright lines,” additional rules, and interpretive guidance to help them determine how to meet the letter and spirit of the law in a cost effective manner.

So before we can even begin to address this issue, we need to understand the many faces of “complexity,” and make sure that we are all working to solve the same problem.

Compliance Trumps Communication?

While a diversity of opinion existed on the nature of “complexity,” members of FEI’s financial-reporting complexity roundtable did agree on a number of topics.

Subjectivity creates uncertainty, and, unfortunately, due to the expanded regulatory and litigious environment in which we operate, it is becoming increasingly difficult for companies to remain confident relying upon and standing by their own professional judgment. What if someone else comes up with a different answer? Was the original answer then wrong and hence culpable?

First, all agreed that the current unforgiving financial-reporting environment—in which decisions are second guessed by auditors, forced into reconsideration by the PCAOB, reexamined by the SEC, and then ripped apart by the plaintiffs bar—is not exactly conducive to simplification. Subjectivity creates uncertainty, and, unfortunately, due to the expanded regulatory and litigious environment in which we operate, it is becoming increasingly difficult for companies to remain confident relying upon and standing by their own professional judgment. What if someone else comes up with a different answer? Was the original answer then wrong and hence culpable? This situation has become increasingly challenging for companies, especially as the concept of materiality has diminished to nearly zero (a subject for another column, I’m sure).

Members of the FEI complexity roundtable also all agreed that the relevance of financial reporting has declined. That’s because, in today’s environment, compliance trumps communication—many companies have been focusing on regulatory requirements, rather than ensuring that the right story is being communicated. This exacerbates a disclosure-risk dynamic that has always existed in financial reporting. When I was crafting my first MD&A as a young accountant at a large public company, I remember adding an overview section that matched the comments of the company’s chairman in his letter to shareholders; in my naivete, I thought this would be meaningful disclosure. The message I got from our legal department: Get rid of it immediately, and please simply update last year’s MD&A and with this year’s numbers.

That was many years ago (more than I care to admit), but the dynamic remains and is even more tense in the current environment.

The roundtable members also agreed that “short-termism” is not healthy for financial reporting. Unfortunately, this is a vicious cycle that we have created for ourselves—the media, stock analysts, and certain investors (both large and small) continue to take a short-term view, and companies are subsequently forced to do the same. Until we break this cycle, it will continue to be difficult for companies to focus on the long term.

Keeping It Simple

So where do we go from here?

FEI’s financial-reporting complexity roundtable was extraordinarily eye-opening for all parties involved, but the conversation should not stop there.

A great first step would be the creation of a blue-ribbon commission, representing all constituencies, with the goal of creating some holistic solutions to solving the issue of complexity. FASB Chairman Robert Herz, whom I adore and with whom I have worked closely over the last few years, has championed such an approach for quite some time. Bob is genuinely concerned about how the current environment impacts standard setting and believes reduction of complexity is critical to the efficiency of our capital markets.

The SEC has also been talking about dealing with complexity for quite some time. Former SEC Chief Accountant Donald Nicolaisen addressed this topic nearly two years ago, when discussing the SEC’s report on off-balance-sheet transactions. “Our work on that report,” said Nicolaisen in a speech at USC, “combined with my prior experiences, confirms for me the need to reduce complexity while at the same time improve both the transparency and usefulness of financial reporting for investors.”

Chairman Christopher Cox was even more explicit when discussing the topic in a December 2005 speech. “If the SEC is truly to succeed in helping investors and in ensuring compliance with the law in the securities industry,” he said, “we'll need nothing less than an all-out war on complexity.”

Those sentiments were echoed by SEC Chief Accountant Conrad Hewitt, who stated earlier this year that he wanted to work with the FASB, AICPA, PCAOB, FEI, and others to begin a project to eliminate unnecessary complexity in financial reporting. “The more I am involved with our accounting standards,” he said in January, “the more I am convinced that we need to eliminate standards that are overly complex, difficult for issuers to implement without extensive outside assistance, and that are difficult for the average investor to understand.”

So, should such a blue-ribbon commission be created, I offer the following advice:

Focus on the “KISS” principle (Keep It Simple, Stupid). Don’t try to solve every financial-reporting issue. One pitfall of such blue-ribbon commissions is that all sorts of “pet projects” get carried onto the agenda, which only serves to bog the process down. The commission needs to stay focused, keep it simple, and keep their collective eyes on the big picture.

Technology can help, but it’s not a panacea. Interactive data—or, officially, eXtensible Business Reporting Language, which the SEC has been aggressively promoting for almost three years— can be an extremely helpful tool in enabling comparability and eliminating some complexity in financial reporting. And, personally, I am a big proponent of XBRL. However, technology is not the only answer in addressing complexity. XBRL can be part of the solution, but all parties should be careful not to overstate its capabilities.

Check your personal agendas at the door. All participants in a blue-ribbon commission would represent an important financial-reporting constituency. However, the members need to recognize that change will be required by all. Regulators will truly need to migrate to principles-based directives. Standard setters will need to avoid rules-based guidance and will have to “just say no” to request for bright lines. Preparers and auditors will need to stop demanding exceptions and clarifications. Financial-statement users will need to rely upon their analytical skills where judgment is required. And the litigation pendulum is going to have to swing in a new direction, or all other changes will be for naught.

Independence is crucial. The leader of this blue-ribbon commission on financial-statement complexity must be beyond reproach and must not be affiliated with any one constituency. In fact, the group itself needs to be commissioned by either the SEC or Congress; any other constituency convening such a group would be perceived as biased.

I am very optimistic that the issue of complexity in financial reporting and standard setting can improve immensely. It would be naïve to expect that complexity could be eliminated; the very essence of financial reporting, combined with the nature of economics, risk, and global business, would make that impossible. But it can be improved, and the fact that all parties want to talk about complexity is a good thing.

It is the first step towards resolving it.

Now let’s take the next step, and convene that panel.