From the September 2007 issue of Investment Advisor • Subscribe!

Simplifying Financial Reporting

SEC committee takes first stab at huge task under SOX

The SEC's Advisory Committee on Improvements to Financial Reporting held its first meeting August 2 at SEC headquarters in Washington to discuss ways to tackle the enormous task of simplifying the U.S. financial reporting system. The landmark Sarbanes-Oxley legislation, which was signed into law in July 2002, called for an examination of the complexity of the current U.S. financial reporting system. The committee will present its proposal to the SEC next August.

Advisory Committee Chairman Robert Pozen, who is also chairman of MFS Investment Management, said companies are now attempting to report a voluminous amount of data under requirements set out in U.S. GAAP and SEC reporting rules. Because it's impossible to fix the entire reporting structure, Pozen suggested the committee should focus instead on five areas as it contemplates how and where to make changes. Pozen's suggested areas are: substantive complexity, the standard-setting process, audit process and compliance, delivering financial information, and international coordination. He suggested creating subcommittees to handle each area.

One reason improvements need to be made to the reporting structure, Pozen said, is the large number of company restatements that have occurred--10% of U.S. companies restated their financial reports in the last year, which is costly for them. "Preparers and auditors who put together financial statements are trying to get it right," he said, "but the high number of restatements" shows a "high error rate." Linda Griggs, a partner in the law firm of Morgan Lewis in Washington, added that in the last 10 years, "financial statements have become increasingly difficult to prepare." She said the committee should study the reasons why so many restatements have occurred. Pozen noted that the U.S. Treasury Department is commissioning a study to determine why there's been such a sharp rise in the number of restatements, adding that the subcommittee that focuses on restatements "should monitor the U.S. Treasury's work in this regard."

Different Constituencies

Financial reporting modifications need to occur, too, because investors have a hard time understanding financial reports, Pozen and other members of the committee agreed. On the flip side, more sophisticated investors complain there's not enough "nitty-gritty" information included in financial reports to satisfy them. Because "there are lots of different users of financial statements," said committee member Susan Bies, a Federal Reserve Board Governor from 2001 to 2007, the challenge will be to create guidelines that address these varying needs.

Making sure the financial reporting process is "more useful for those who rely on it is the big issue," added Michael Cook, retired chairman and CEO of Deloitte & Touche. The committee, he said, needs to devote "serious attention to the financial information that flows from the financial statement to the investor." The earnings statement, he continued, "is where companies provide the valuable information to investors. The earnings release often moves markets." Pozen added that the growth of press releases on companies' earnings--in which companies tout what they think is important--may not present the most useful data.

A Principles-Based System?

Much talk has been made of the U.S. adopting the principles-based reporting system used in the U.K. But Pozen opined that he doesn't believe this is the solution. "The real question," he asked, "is how do you mix principles and rules?" Griggs concurred that it's "difficult to articulate principles-based standards." In the discussion paper laying the groundwork for improvements to the reporting system, Pozen said "complexity may be created not by the adoption of principles versus rules, but rather as a result of competing principles." He went on to say that U.S. GAAP, for example, "is not consistent on the appropriate measurement attribute to use for valuing financial assets and liabilities. In areas like financial reporting, there are two basic principles: lower of cost or market, and fair value." The subcommittee may wish to consider, he said, "to what extent mixed measurement attributes (fair value versus historical cost) have increased complexity and reduced transparency, and what changes should be made to our capital markets to allow for more consistent measurement attributes."

Denny Beresford, Ernst & Young Executive Professor of Accounting at the University of Georgia, and former chairman of the Financial Accounting Standards Board (FASB) from 1987 to 1997, said the committee should study the "relevance" of U.S. GAAP along with its complexity.

Joe Grundfest, a Stanford law professor and former SEC commissioner, suggested the committee set up a blog or other form of communication that allows "knowledgeable" folks to offer their comments on modifications that need to be made. He also said the committee should "jump start" the adoption of XBRL, an interactive data tagging technology that allows users to quickly and easily focus on the information they want to access in financial reports.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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