The Securities and Exchange Commission’s Advisory Committee on Improvements to Financial Reporting has kept itself busy this spring. In February, it issued a progress report that summarized its potential recommendations to simplify financial reporting; in March and May, it held follow-up meetings to discuss those ideas more thoroughly. I’ve already written about CIFR’s recommendation regarding a professional judgment framework, but there are a lot of other interesting potential recommendations that deserve some consideration, too—not just from the members of the committee, but also from Compliance Week readers.
The recommendations discussed in the progress report would, if adopted, result in changes to many of the structures that support and define U.S. financial reporting. On the whole, the set of recommendations would move things in the right direction. However, there are some areas that CIFR has not discussed (or at least not discussed in much depth) that require some focus and attention if we want to make significant improvements.
Comment Letters
I’ve written before that I believe that the SEC sincerely wants to do its part to reduce complexity, and to accept reasonable judgments made by issuers in preparation of their financial statements. In the year and a half since I left the SEC, those beliefs have been reinforced many times. But I’ve also seen instances where the staff’s actions didn’t seem consistent with the notions of reducing complexity, respecting reasonable judgments, and tolerating diversity in interpretation.
Most constituents have their primary interaction with the SEC via comment letters. And it is through comment letter exchanges that many people have come to the conclusion that the SEC doesn’t tolerate diversity in application of accounting principles or respect judgments that differ from the staff’s own views. The last 18 months working with issuers to resolve SEC comments has given me a new appreciation for some of these concerns.
SEC staff comments are generally on point, and the majority of issues are handled in a way that reflects an appropriate understanding of the difficulty and judgment that is part of preparing and auditing financial statements. But I have seen multiple examples that appeared to reflect one or more of the following:
A drive to apply rules-of-thumb that do not appear in the accounting literature. For example, the staff has expressed the view that operating segments cannot be economically similar (and, therefore, qualify for aggregation) if certain measures differ by more than 10 percent.
Reliance on SEC staff speeches as the underlying support for a particular position. It should never be just the speech that is used to support a view, but the literature on which the speech was based.
The use of language such as “please revise your accounting” before the staff has gathered sufficient information to understand the basis for the company’s original accounting. This sometimes leads companies to restate unnecessarily.
A desire for uniformity in interpretation of principles-based guidance.
The use of hindsight in evaluating judgments and estimates.
The view that an error that exceeds a particular threshold (usually 5 percent) is material, regardless of any other factors.
In many of these cases, I suspect that there was good reason for the staff’s comment that wasn’t evident to me from reading the comment letter itself. Still, companies and auditors come away from these discussions believing that the SEC staff will not really respect judgments, no matter what its senior people say.
CIFR’s progress report does not delve into the comment letter process, but it’s an area that deserves attention. One suggestion I’ve heard several times in the past is that the Office of the Chief Accountant be involved in reviewing all or some portion of comment letters. While this might identify some comments that would be better left unmade, I fear it would complicate the process immeasurably. There are better ways to ensure comment letters are focused appropriately.
The SEC staff might start with an internal review of completed comment letter exchanges. This would allow the staff to consider whether the comment process furthers the SEC’s policy goals, and if it is not always doing so (as I suspect), the staff could evaluate what changes might better align the two. The review might also highlight situations that are handled differently by different reviewers, identify examples of how issuers can best respond to comments, and help the staff identify patterns of issues earlier than they might otherwise do so. Such a review would be time consuming, but could be performed by a small group of staff without interrupting the ongoing work of the Commission.
SEC Accounting Guidance
A significant amount of accounting guidance has been issued by the SEC and its staff in various forms. I’m not talking about speeches here; speeches aren’t authoritative and shouldn’t be treated as such. Rather, I’m referring to accounting guidance in Regulation S-X, Accounting Series Releases, Financial Reporting Releases, Staff Accounting Bulletins, and announcements at Emerging Issues Task Force meetings. The CIFR progress report discusses a recommendation that the SEC refrain from issuing broadly applicable guidance unless absolutely necessary. This is a good start, but I don’t think it’s enough. For one thing, the SEC already has been operating with that goal for some time. For another, I believe the SEC staff needs to do more to convince constituents of its commitment to reducing complexity.
In general, the SEC has issued accounting guidance for one of the following underlying reasons:
To fill gaps in the accounting literature. Regulation S-X’s guidance on financial statement captions, SAB Topic 13 on revenue recognition, and ASR 268 and EITF Topic D-98 on redeemable equity are examples of this kind of guidance.
To stop abusive transactions that probably never should have been considered acceptable in the first place. SAB Topic 5.e. on sales of businesses to thinly capitalized shell companies is a prime example of this.
To explain how GAAP and SEC rules interact. Portions of SAB Topic 14 on share-based payments focus on non-GAAP measures and Management Discussion & Analysis disclosures, for example.
Much of this guidance is being integrated into the Financial Accounting Standards Board’s codification of Generally Accepted Accounting Principles, which will greatly improve its accessibility. But the real goal should be to eliminate as much of the SEC guidance as possible and leave GAAP in the hands of FASB (or perhaps IASB, in the not-so-distant future).
The SEC staff could take the next step by identifying guidance that fits my first category above and explaining which FASB projects will resolve the gap the SEC literature was meant to fill. The staff could also identify the SEC-promulgated guidance intended to stop abusive transactions and consider whether there is a more effective way to stop those intent on deception from abusing the accounting literature in general, instead of issue by issue. For example, a policy statement regarding the intent of the SEC to pursue those who engage in abusive accounting-motivated transactions might do a better job than the patchwork of rules-based guidance that has been issued. The remaining guidance (from the third category above) could then be integrated with other explanatory material regarding the applicable SEC rules. By publicly taking steps like this, the staff would help reduce complexity in a tangible way and, importantly, reinforce with constituents that the SEC is committed to doing its part.
Investor Perspective and Involvement
The CIFR progress report correctly points out that investor perspectives should be paramount in standard setting. This is a simple but powerful goal. The progress report says we can encourage this by increasing representation of investors on the Financial Accounting Foundation, FASB, and the FASB staff. I wonder, though, exactly what problem we are trying to solve. The issue does not really seem to be a lack of knowledge about what investors want (because there are plenty of examples where we have known exactly what investors wanted) but a lack of knowledge of why we didn’t do it.
For example, if investor views had pre-eminence, stock options would have been expensed based on their fair values back in the early 1990s. There would be no smoothing of pension costs and no held-to-maturity classification for marketable financial assets. We would also not have come up with Financial Accounting Standard No. 159, which provides an option to record financial instruments at fair value with changes going through earnings. All of these are examples where the investor view was known and could have been implemented, but FASB went another way because of the views of other constituents.
One benefit of assembling a group like CIFR was to get representatives from all financial-reporting constituencies to discuss issues together and come up with solutions that they can all support. In truth, FASB and SEC have generally tried to make investor views pre-eminent. But preparers, in particular, have often argued that other concerns should take precedence. If CIFR’s recommendation on making investor views pre-eminent is to have strength, preparers and others will need to be committed to supporting that outcome. As such, the recommendation in the progress report seems incomplete to me, because it doesn’t discuss working with preparers, auditors, and others to ensure that they will support standard setting and regulatory efforts that give investor views more weight.
Preparers Can Reduce Complexity, Too
Much of the discussion and several potential recommendations are focused on reducing complexity in financial reporting by asking FASB and the SEC to do things differently. I agree that FASB and the SEC can make changes to make things simpler for preparers and more understandable for everybody without compromising the usefulness of financial reporting. But reporting companies, if they were serious about reducing complexity, could make many changes themselves without waiting for regulators or standard setters.
An example I’ve used before is the accounting for defined-benefit pension plans. Accounting standards allow for the reporting of pension commitments using the most current estimate of the obligation and the best estimate of the value of the assets in the plan. But virtually every company chooses to defer various gains and losses, requiring additional tracking, reclassifications between other comprehensive income and net income, additional explanation in the footnotes, and more assumptions and analysis.
Similar examples abound. Companies choose LIFO instead of FIFO for inventory accounting, requiring them to track their inventory two ways. Companies that use the held-to-maturity and available-for-sale categories of accounting for marketable securities subject themselves to a judgmental impairment test and additional disclosure. Other companies complicate their financial reports with boiler-plate language and unimportant information in their MD&A, apparently because they feel safer doing this than actually focusing on only important items. And this doesn’t even get into hedge accounting, the mother of all complex, but not required, methods of accounting.
Clearly, other goals sometimes take precedence for preparers over reducing complexity. This is further illustrated in comments on FASB proposals. When FASB proposed changes to its standards on business combinations and consolidation (the proposals that led to FAS 141R and FAS 160), many of those commenting complained, correctly, that the proposals related to contingencies would add complexity. But very few complimented the proposals related to consolidation procedures for their capacity to significantly reduce complexity. If we are to make reducing complexity a focus of our efforts, FASB must be given credit for proposals that accomplish the goal.
Perhaps, then, what is missing in the CIFR progress report are recommendations focused on getting preparers to buy into efforts to reduce complexity. It isn’t sufficient for CIFR just to tell FASB to stop creating the complexity, while not targeting some efforts at reducing the requests that lead to the alternatives, scope exceptions, and bright lines that the advisory committee believes are elements of the current complexity.
Looking Ahead
CIFR was asked to complete a broad task in a short period of time. Its members have worked diligently to consider recommendations in many areas that hold the promise of improvements to financial reporting. I hope that whatever momentum exists to make some improvements does not dissipate after CIFR delivers its final report this summer. Whether or not the CIFR recommendations are best, we can improve financial reporting for all participants in the process. It would be a shame if the current unrest in the financial markets and other events resulted in missing the opportunity to make those changes.
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