Numerous restatements prompt SEC to assess financial reporting
At the end of July, SEC chairman Christopher Cox assembled an Advisory Committee on Improvements to Financial Reporting to quell the dissatisfaction that surrounds the complicated subject. A feeling of hopelessness about how to solve the difficulties in financial reporting pervades many corporate spheres. As such, representatives from numerous fields affected serve on the committee.
The first meeting kicked off in early August, featuring input from Ernst & Young, the Federal Reserve, Deloitte & Touche, TIAA-CREF and AICPA, and representing a wide variety of areas including Fortune 500 audit committees, pension funds, securities attorneys, credit rating agencies and proponents of interactive data for financial reporting.
Harvard professor Robert Pozen is vice chairman of the advisory committee, which Ralph Allen, managing partner at Beacon Advisors, thinks is a good choice given his experience as vice chairman at Fidelity Investments and president of Fidelity Management and Research company, which put him ‘in the trenches with public companies.’ Cox has been egalitarian in his committee selection process, making sure to allow for contributions from each critical financial policy-maker: the Financial Accounting Standards Board (FASB), the Public Company Accounting Oversight Board (PCAOB), the US Department of the Treasury and the International Accounting Standards Board (IASB) as well as federal banking regulators.
According to an SEC press release, the committee ‘will examine the US financial reporting system and provide recommendations about how to improve its usefulness for investors and reduce unnecessary complexity for US companies.’ Representing investment professionals on the committee, Jeffrey Diermeier, president and CEO of CFA Institute, says discussion has so far focused on ‘substantive complexity, setting of standards, audit process and compliance (around the liability issue) and information delivery.’ As for the big topics to come, Diermeier says they will most likely involve the ‘global convergence of accounting standards.’
Diverse audience creates complications
This latest effort to change financial reporting tactics comes after complaints from investors who find reports unintelligible and companies that find the process cantankerous. This disillusion is manifested in a whopping statistic: ‘During 2006, almost 10 percent of US public companies had to restate prior financial reports due to the discovery of errors in those reports,’ states an SEC press release.
Diermeier attributes the crisis to the diversity of the investor community, which ‘creates confusion for providers and preparers of financial information.’ On top of that, users may prefer ‘segment information in multi-line businesses,’ while companies may not wish to disclose too much information. Pozen also speaks to the differing perspectives: ‘Preparers often want less volatility in earnings, implying less fair value measures, while users generally prefer that more assets and liability reflect their current values.’
Because of the tendency to ‘over-simplify an issue with a complex range of results,’ Pozen says a subcommittee will address these issues, including ‘the level of detail that is desired by each type of user.’
In a comment letter to the SEC, Allen writes that investor relations input could help inform on what investors want. He suggests Lou Thompson to fit the bill. Thompson’s past experience as CEO of the National Investor Relations Institute would enable him to speak on balancing companies’ desires to include sufficient information with investors’ desires to understand the information. Allen says Thompson ‘has long advocated plain English reporting by public companies,’ adding that ‘some of these things need to be stated with words of few syllables at the beginning and then develop as they continue.’
With experience as IR chief writing annual reports for Kodak and ITT, Allen has learned that ‘most serious investors read the chairman’s letter … and an awful lot of the other stuff they just flip right by it.’ And as an accountant, trained to write those footnotes, he admits the tedium of interpreting them.
Compare yourself
Pozen also notes the importance of comparability: ‘Users may prefer a uniform format that makes comparisons easy, while preparers may want special rules that allow them to present what they believe are the unique aspects of their industry.’
The potential that companies will be filing under both GAAP and IFRS could make it extra tough to compare reports. Companies are wondering what the rules will be, and investors are wondering how they’ll be able to compare reports filed under different standards. ‘GAAP is not consistent on the appropriate measurement attribute to use for valuing financial assets and liabilities,’ Pozen says in his charter, and that creates conflict between two basic principles: lower of cost or market, and fair value. A standard-setting process committee will look more closely at GAAP, which FASB is working to codify. He says misunderstanding of rules and differing applications account for these irregularities. Since costs are not known until after rules are implemented, the committee will reevaluate methods to tests costs.
OK computer
Companies are equally unsure of methods for the delivery of financial information in terms of investor access. Namely, as laid out in an SEC press release, the ‘tagging of information; via XBRL, an interactive data tagging technology promoting quick-access and an ability to customize needs, performance metrics for carrying out the strategy of a specific company [and] key performance indicators organized by industry.’ The SEC is on the verge of making XBRL mandatory, which will help elucidate information by ‘making financial information more useful to investors and others who use it.’
Peter Wallison, co-director of the American Enterprise Institute’s program on financial market deregulation and former general counsel in the Treasury department, is the new committee’s XBRL representative. He says XBRL would be a ‘huge advantage for investors … because it makes all the information … machine readable.’ Without the necessity of downloading separate 10Ks, you can ‘download all of that data in seconds into a spreadsheet.’ Diermeier also approves of XBRL: ‘Investing is an act of comparing one investment to another … Therefore the potential for improved ease of comparing companies, specific elements and notes in details from one company to the next will enhance analysis, improve transparency and eventually lead to a better functioning market.’
‘Unfortunately, companies don’t really understand the advantages they could gain from XBRL,’ says Wallison. Only 40 companies had joined the SEC’s voluntary XBRL filing program as of September. Those that have gone the route of XBRL have largely been integrating all their financial information, ‘so that they don’t have to do a lot of the manual work that all companies now do when they transfer their operating data … into their financial information.’
So why aren’t companies jumping on the XBRL bandwagon? ‘Nobody in companies has been tasked to sit down and investigate XBRL,’ Wallison says. ‘They don’t realize that all of their data can be worked together using XBRL without having to do a lot of manual work to compile it.’
XBRL won’t necessarily help relieve suspicions around financial statements as it doesn’t change the information itself, concedes Wallison. Though the committee is just beginning talks on XBRL, he says, ‘It is clear from the discussions that we’ve had that there are a number of members of the committee that have already found that XBRL is going to be very helpful.’
Bridging the divide
In another comment letter submitted to the committee, Edward Dodds, a strategist and systems architect for Conmergence, advocated the participation of the Open Compliance and Ethics Group (OCEG). OCEG chairman and CEO Scott Mitchell sees compliance as integral to finding a solution for the financial reporting conundrum, so it’s an area that should have representation on the advisory committee. He says examining the broad portfolio of risks is necessary to understanding any one factor: ‘When you mash them all together, you find each discipline has a lot to add, but fundamentally they’re doing the same thing. If we take the best practices from each of those silos and apply it to the other we have a much stronger structure in place to deal with compliance across the board.
‘In terms of strengthening financial reporting, compliance and all the structures behind that, I think there’s a lot to be learned from the other disciplines,’ he adds. This, by extension, would drive down the costs, he says. ‘The goal is compliance, and to manage risks … We just want to know that the company’s on track.’
There are critics of Mitchell’s view, however. Diermeier thinks compliance has instilled unnecessary fear: ‘The degree to which company management is driven to treat financial reporting as a compliance exercise, and is restricted in their ability to talk about business fundamentals because of fear of strict liability with respect to their formal filings, benefits no one and is in serious need of repair.’
Either way, a more unified approach has a gestalt logic to it. ‘Part of the solution here is for companies to have robust big-picture programs that are aimed at effective governance risk and compliance of all types, not just financial,’ says Mitchell. This in turn could mean investments in SOX controls could strengthen other areas by cross-pollination, thereby reducing costs.
But Allen notes that many perspectives can compound issues, especially the ever-refined regulations: ‘With new regulations, you get a layering effect’ in financial reporting, he says. ‘[Companies] leave what they said before and add something new.’
Still in its early stages, the committee is not expected to make financial reporting recommendations until August 2008. Diermeier reveals that they still ‘need to bring in some viewpoints of others and address some of the questions we currently have.’
Not surprisingly, one of the most pressing questions is ‘why only a few companies have filed under the voluntary [XBRL] program.’ Certainly, the one integral component for these changes to work will be companies’ willingness to accept them.
