Tuesday, July 15, 2008

SEC Advisory Committee on Improvements to Financial Reporting (Pozen Committee) Issues Final Report

The SEC Advisory Committee on Improvements to Financial Reporting (Pozen Committee) has issued its draft 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.

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 logical presentation of disclosures, based on consistent objectives and principles. This would eliminate redundancies and provide a single source of disclosure guidance across all financial reporting standards.

FASB should also disclose the principal assumptions that may impact a company’s business, as well as provide a qualitative discussion of the key risks and uncertainties that could significantly change these amounts over time. This would encompass transactions 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 urges the SEC to issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers in making the evaluation. The statement of policy should also address the choice and application of accounting principles. Similarly, the PCAOB should develop guidance on how the Board, including its inspections and enforcement divisions, would evaluate the reasonableness of judgments made 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 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. This may require the FASB to re-evaluate the roles and composition of other advisory groups or agenda committees. One or more key decision-makers from the SEC, the FASB, and the PCAOB should sit on the FRF, which would allow coordination of how and by whom guidance should be issued, thereby reducing the impetus for the SEC to issue interpretive implementation guidance.

On that point, the committee asks 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. Also, 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 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 endorses the US 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. See Basic, Inc. v. Levinson and TSC Industries, Inc. v. Northway, Inc., When looking at how an error impacts the total mix of information, reasoned the committee, one must consider all of the qualitative factors that would impact the evaluation of the error. This is why bright lines or purely quantitative methods are not appropriate in determining the materiality of an error to annual financial statements.

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 is often not adequate to allow investors to evaluate the company’s operations and the likelihood that such errors could occur in the future. Thus, the committee urges the SEC to issue guidance on the disclosure if 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.