Saturday, August 09, 2008

Final Report of SEC Advisory Committee on Improvements to Financial Reporting Impacts PCAOB

By James Hamilton, J.D., LL.M.

The SEC Advisory Committee on Improvements to Financial Reporting has issued its final report recommending major changes to regulation and standard-setting involving financial statements and the independent audit of them. 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 its recommendations on areas where the SEC, FASB, and the PCAOB could act in a reasonable time. 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 accounting standards, the committee did not focus on the ongoing convergence of US GAAP and IFRS. The committee believes that the principles underlying its recommendations are relevant no matter how convergence ends up.

Professional Judgment

In recognition of the increasing exercise of accounting and audit judgments in an era of principles-based standards, the committee urged the SEC and PCAOB to adopt policy statements on this subject. These policy statements would provide more transparency into how the SEC and the Board evaluate the reasonableness of a judgment made by an accountant or auditor of financial statements. This transparency is needed, the committee reasoned, in order to assuage the concern of auditors in a principles-based environment that their judgments will not be second-guessed after the fact

In the committee’s view, the statements should also encourage preparers and auditors to follow a disciplined process in making judgments. In addition, as a result of the policy statements, investors should have more confidence in how accounting and auditing judgments are exercised.

The committee set forth a number of factors it considers important in evaluating professional judgment, including the available alternatives a company identified and the robustness of a company’s analysis of the relevant literature and review of the pertinent facts. The evaluation by the oversight bodies should also consider the degree to which a company’s approach is consistent with current accounting practice and how a company’s conclusions meet the information needs of investors. Further, the policy statements should emphasize the contemporaneous documentations of professional judgments in order to ensure that the evaluation is based on the same facts that were reasonably available at the time the judgment was made.

More specifically, the committee believes that the PCAOB’s statement of policy should acknowledge that the Board will look to the SEC’s statement of policy to the extent that the Board would be evaluating the appropriateness of accounting judgments as part of an auditor’s compliance with PCAOB auditing standards.

Financial Reporting Forum

The committee also suggested the creation of a Financial Reporting Forum that would include key constituents from the preparer, auditor, and investor communities. Forum members would meet with representatives from the SEC, the FASB, and the PCAOB to discuss pressures in the financial reporting system overall, both immediate and long-term, and how individual constituents are meeting these challenges. This may require the FASB and PCAOB to re-evaluate the roles and composition of their advisory groups. For example, the involvement of preparers, auditors, and investors could be effectuated by leveraging members or executive committees from existing FASB or PCAOB advisory groups and agenda committees. It is envisioned that one or more key decision-makers from the SEC, the FASB, and the PCAOB will participate in the FRF.

Internal Controls


The committee praised the efforts of the SEC and PCAOB to effectively implement the internal control mandates of section 404 of the Sarbanes-Oxley Act. But, while internal control over financial reporting has been strengthened in recent years, there is evidence indicating that material weaknesses in internal control are often identified after a financial reporting problem has arisen, and perhaps only as a result of the event itself.

In the committee’s view, financial reporting would be improved if there was more timely identification of material weaknesses, and remediation of those weaknesses to prevent errors from occurring in the first place. Thus, the committee encouraged the SEC and the PCAOB to continue to stress the timely identification and correction of weaknesses, with appropriate emphasis on tone at the top and corporate governance as key factors that will lead to early identification and timely action, particularly as they relate to the potential for fraudulent financial reporting.