Investor groups are raising alarms that the high-profile committee studying ways to simplify financial reporting might actually make things worse with some proposals on how to handle materiality and the correction of financial statement errors.
The Securities and Exchange Commission’s special Committee to Improve Financial Reporting held a two-day public meeting earlier this month in California, where numerous participants—mostly those representing investor groups—worried that supposed fixes to materiality and error correction would make financial reporting less transparent. In particular, they panned ideas to change the current standard for materiality so that some large errors still could be considered immaterial and to state that prior-period financial statements should only be restated for errors material to those prior periods.
Pozen
The discussions, held March 13 and 14, were intended to gather feedback on some of CIFR’s proposals. Those draft proposals were detailed in a progress report published for comment on the SEC Website in February. Formed last year and led by MFS Investment Management Chairman Robert Pozen, the committee will make its final recommendations to the SEC this August.
CIFR has proposed new guidance on materiality and error corrections based on the perspective of a “reasonable investor.” Under a recommendation in CIFR’s draft report, a material error would not require a restatement of the annual financial statements if that error has no relevance to an investor’s assessment of those annual statements. The error would still need to be disclosed and corrected in the current period, such as through a Form 8-K filing.
Roper
CIFR says its intention is to reduce the number of unnecessary restatements, which it says contribute to complexity in financial reporting. But Barbara Roper, director of investor protection at the Consumer Federation of America, fired away at the proposals, saying they would weaken the materiality standard and provide less transparency around the reporting of financial statement errors.
Roper said the committee’s report provides no evidence that a significant number of unnecessary restatements actually occur. Moreover, she added, the report “hasn't provided any evidence that the benefits of reducing these restatements, if they are indeed unnecessary, outweighs the risks that material errors will go uncorrected if the proposed changes are adopted.”
She said a standard that allows certain quantitatively large errors to be deemed immaterial based on qualitative factors, would be abused if adopted. “Past experience tells us encouraging a move in this direction is just a bad idea,” she said. “Think Enron in 1997, when Arthur Andersen acquiesced to Enron’s argument that adjustments that would’ve reduced its net income by nearly 50 percent were immaterial.”
Elizabeth Mooney, an analyst with The Capital Group Companies, contended that the current guidance for assessing materiality is appropriate and shouldn’t be tweaked. “On behalf of investors … please don’t change a word of SAB 99,” Mooney told the group.
Conversely, Manish Goyal of TIAA-CREF was largely supportive of the proposals. He said the committee’s approach was preferable in some cases to the lengthy “dark period” a company enters when it works on a restatement.
And Other Flashpoints
Another CIFR proposal that drew some fireworks was its call for the SEC to adopt some sort of “judgment framework” for accounting to give companies and auditors a blueprint of how to decide tricky financial reporting problems that could have more than one possible answer. Most at the CIFR meeting supported the concept, although others voiced concern about what form such a framework would take.
CIFR SAYS
Below are two proposals developed by the SEC’s Advisory Committee on Improvements to Financial Reporting.
Developed Proposal 2.1: GAAP should be based on activities, rather than industries.
Any new projects undertaken separately by the FASB or IASB should be scoped on the basis of activities rather than industries.
Any new joint projects between the FASB and the IASB should be scoped on the basis of activities rather than industries, and should include the elimination of existing industry-specific guidance in relevant areas as a specific objective of those projects, unless in rare circumstances, retaining such guidance can be justified.
In conjunction with its current codification effort, the FASB should add a project to its agenda to remove or minimize existing industry-specific guidance that conflicts with generalized GAAP prior to achieving full convergence.
Developed Proposal 5.1: The SEC should mandate the filing of XBRL-tagged
financial statements within a defined time … 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 with the voluntary program today, a document prepared separately from the reporting company’s financial
statements filed as part of their periodic Exchange Act reports that contains the following: XBRL tagged face of the financial statements and block tagged footnotes to the financial statements.
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; and
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 official filing of XBRL tagged financial statements
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.
Source
Advisory Committee Draft Decision Memo (Jan. 11, 2008).
CIFR member Thomas Weatherford, former chief financial officer for Business Objects, warned that “young auditors and CFOs are walking away from making a judgment,” which only makes financial reporting rules more exacting and complicated. A judgment framework, he said, “starts us on the process of trying to get judgment back at the field level.”
Johnson
Dennis Johnson, a corporate governance manager at the California Public Employees Retirement System, said a professional judgment framework that includes input from investors and the Financial Accounting Standards Board could be a good idea. But he and most others stressed that the framework should not take the form of a safe harbor.
Jonathan Chadwick, senior vice president and corporate controller at Cisco Systems, also cautioned the committee to ensure that application of a framework doesn’t create additional documentation requirements for companies.
But Salvatore Graziano, a partner at Bernstein Litowitz Berger & Grossmann who serves as securities litigation counsel for institutional investors, called the proposed framework “bad for investors” because it would make the pursuit of fraudulent accounting by regulators and civil litigants even more difficult.
Graziano
“I’ve seen firsthand how difficult these cases already are to prosecute against issuers and accountants,” Graziano said. “I’m concerned that the proposal will further raise this bar to a level that will be quite difficult to meet even in the most meritorious cases.”
Also discussed was a recommendation that the SEC phase in mandatory use of XBRL to file financial statements, starting only with the largest public companies first. That should give Corporate America more time to digest the new technology and answer any questions about legal liability, auditor assurance, and cost.
The SEC staff is now preparing a rule proposal on the use of XBRL, or eXtensible Business Reporting Language. SEC Chairman Christopher Cox wants to have a final rule for adopting the technology approved by the end of the year, but many are urging a go-slow approach to avoid a repeat of the costly fiasco of Sarbanes-Oxley compliance earlier this decade.
Hanson
While participants at the meeting were largely supportive of CIFR’s proposals for XBRL, many worried how implementing the technology might affect smaller companies. Gregory Hanson, CFO of ADVENTRX Pharmaceuticals, a small public biopharmaceutical company, questioned whether sufficient service providers and infrastructure exist to support widespread implementation.
He also wondered how small companies with limited staff could implement XBRL while grappling with existing regulatory requirements, such as SOX Section 404, fair-value accounting and FIN 48, as well as likely future obligations, such as the move to international financial reporting standards. Hanson said the estimates he’s gathered from third-party service providers to outsource the tagging of the company’s financials in XBRL range from $10,000 to $20,000 annually, with additional internal costs of roughly $20,000 more.
“I’m in favor of implementing XBRL … but I’ve had some concerns in how it’s implemented and when it’s going to be required of small companies,” said Hanson, who oversees a four-person accounting staff at a company of 32. He suggested small companies be given “at least an additional year before they have to implement this, or until we know the benefits exceed the costs.”
CIFR plans to hold further public meetings in Chicago in May and in New York in July.
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