
[Federal Register: May 22, 2008 (Volume 73, Number 100)]
[Notices]               
[Page 29808-29832]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22my08-99]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release Nos. 33-8918; 34-57819; File No. 265-24]

 
Subcommittee Reports of the SEC Advisory Committee on 
Improvements to Financial Reporting

AGENCY: Securities and Exchange Commission.

ACTION: Request for comments.

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SUMMARY: The Advisory Committee is publishing four subcommittee reports 
that were presented to the Advisory Committee at its May 2, 2008 open 
meeting and is soliciting public comment on those subcommittee reports. 
The subcommittee reports contain the subcommittees' updates of their 
work through the May 2, 2008 open meeting and contain preliminary 
hypotheses and other material that will be considered by the full 
Committee in developing recommendations for the Committee's final 
report.

DATES: Comments should be received on or before June 23, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/other.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number 265-24 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Federal Advisory Committee Management Officer, Securities and Exchange 
Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File No. 265-24. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comment more efficiently, please use only one 
method. The Commission will post all comments on its Web site (http://
www.sec.gov/about/offices/oca/acifr.shtml). Comments also will be 
available for public inspection and copying in the Commission's Public 
Reference Room, 100 F Street, NE., Washington, DC 20549, on official 
business days between the hours of 10 a.m. and 3 p.m. All comments 
received will be posted without change; we do not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Questions about this release should be 
referred to James L. Kroeker, Deputy Chief Accountant, or Shelly C. 
Luisi, Senior Associate Chief Accountant, at (202) 551-5300, Office of 
the Chief Accountant, Securities and Exchange Commission, 100 F Street, 
NE., Washington, DC 20549-6561.

SUPPLEMENTARY INFORMATION: At the request of the SEC Advisory Committee 
on Improvements to Financial Reporting, the Commission is publishing 
this release soliciting public comment on the subcommittees' reports. 
The full text of these subcommittee reports are attached as Exhibits A-
D and also may be found on the Committee's Web page at http://
www.sec.gov/about/offices/oca/acifr.shtml. The subcommittee reports 
contain the subcommittees' updates of their work through the May 2, 
2008 open meeting of the full Committee and contain preliminary 
hypotheses and other material that may be deliberated by the full 
Committee in considering recommendations for the Committee's final 
report. As such, the Committee would like to request public input on 
the material in these subcommittee reports. The subcommittee reports 
have been prepared by the individual subcommittees and do not 
necessarily reflect either the views of the Committee or other members 
of the Committee, or the views or regulatory agenda of the Commission 
or its staff.
    All interested parties are invited to comment on the enclosed 
subcommittee reports. Comments on the reports are most helpful if they 
(1) Indicate the specific exhibit and paragraph to which the comments 
relate, (2) contain a clear rationale, and (3) include any 
alternative(s) the Committee should consider.

    Authority: In accordance with Section 10(a) of the Federal 
Advisory Committee Act, 5 U.S.C. App. 1, Sec.  10(a), James L. 
Kroeker, Designated Federal Officer of the Committee, has approved 
publication of this release at the request of the Committee. The 
solicitation of comments is being made solely by the Committee and 
not by the Commission. The Commission is merely providing its 
facilities to assist the Committee in soliciting public comment from 
the widest possible audience.

    Dated: May 15, 2008.
Nancy M. Morris,
Committee Management Officer.

    Note: These subcommittee reports have been prepared by the 
individual subcommittees and do not necessarily reflect either the 
views of the Committee or other members of the Committee, or the 
views or regulatory agenda of the Commission or its staff.

Exhibit A

SEC Advisory Committee on Improvements to Financial Reporting

Substantive Complexity Subcommittee Update

May 2, 2008 Full Committee Meeting

I. Introduction

    The SEC's Advisory Committee on Improvements to Financial Reporting 
(Committee) issued a progress report (Progress Report) on February 14, 
2008.\1\ In chapter 1 of the Progress Report, the Committee discussed 
its work-to-date in the area of substantive complexity, namely, its 
developed proposals related to industry-specific guidance and 
alternative accounting policies; its conceptual approaches regarding 
the use of bright lines and the mixed attribute model; and its future 
considerations related to scope exceptions \2\ and competing models.
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    \1\ Refer to Progress Report at http://www.sec.gov/rules/other/
2008/33-8896.pdf.
    \2\ Throughout this report, the term ``scope exceptions'' refers 
to scope exceptions other than industry-specific guidance.
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    Since the issuance of the Progress Report, the substantive 
complexity subcommittee (Subcommittee I) has deliberated each of these 
areas further, particularly its conceptual approaches and future 
considerations, and refined them accordingly. This report represents 
Subcommittee I's latest thinking. The Subcommittee's consideration of 
comment letters received thus far by the Committee is ongoing and may 
result in additional changes. The purpose of this

[[Page 29809]]

report is to update the full Committee, and also to serve as a basis 
for the substantive complexity panel discussions scheduled for May 2, 
2008 in Chicago. Subject to further public comment, Subcommittee I 
intends to deliberate whether to recommend these preliminary hypotheses 
to the full Committee for its consideration in developing the final 
report, which it expects to issue in July 2008.

 II. Exceptions to General Principles

II.A. Industry-Specific Guidance

    In the Progress Report, the Committee issued a developed proposal 
related to industry-specific guidance (developed proposal 1.1). Refer 
to the Progress Report for additional discussion of this developed 
proposal. Subcommittee I will consider the panel discussions on May 2, 
2008, as well as the public comment letters received, before submitting 
a final recommendation to the Committee, but at this time, is not 
intending to propose any significant revisions.

II.B. Alternative Accounting Policies

    In the Progress Report, the Committee issued a developed proposal 
related to alternative accounting policies (developed proposal 1.2). 
Refer to the Progress Report for additional discussion of this 
developed proposal. Subcommittee I will consider the panel discussions 
on May 2, 2008, as well as the public comment letters received, before 
submitting a final recommendation to the Committee, but at this time, 
is not intending to propose any significant revisions.

II.C. Scope Exceptions

    Preliminary Hypothesis 1: GAAP should be based on a presumption 
that scope exceptions should not exist. As such, the SEC should 
recommend that any new projects undertaken jointly or separately by the 
FASB should not provide additional scope exceptions, except in rare 
circumstances. Any new projects should also include the elimination of 
existing scope exceptions in relevant areas as a specific objective of 
these projects, except in rare circumstances.
Background
    Scope exceptions represent departures from the application of a 
principle to certain transactions. For example: \3\
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    \3\ Refer to appendix A for additional examples.
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     SFAS No. 133, Accounting for Derivative Instruments and 
Hedging Activities, excludes certain financial guarantee contracts, 
employee share-based payments, and contingent consideration from a 
business combination, among others.
     SFAS No. 157, Fair Value Measurements, excludes employee 
share-based payments and lease classification and measurement, among 
others.
     FIN 46R, Consolidation of Variable Interest Entities, 
excludes employee benefit plans, qualifying special-purpose 
entities,\4\ certain entities for which the company is unable to obtain 
the information necessary to apply FIN 46R, and certain businesses, 
among others.
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    \4\ Subcommittee I notes that the FASB has tentatively decided 
to remove the qualifying special-purpose entity concept from U.S. 
GAAP and its exception from consolidation.
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    Similar to other exceptions to general principles, scope exceptions 
arise for a number of reasons. These reasons include: (1) Cost-benefit 
considerations, (2) the need for temporary measures to quickly minimize 
the effect of unacceptable practices, rather than waiting for a final 
``perfect'' standard to be developed, (3) avoidance of conflicts with 
standards that would otherwise overlap, and (4) political pressure.
    Scope exceptions contribute to avoidable complexity in several 
ways. First, where accounting standards specify the treatment of 
transactions that would otherwise be within scope, exceptions may 
result in different accounting for similar activities (refer to 
competing models section below for further discussion). Second, scope 
exceptions contribute to avoidable complexity because of difficulty in 
defining the bounds of the scope exception. As a result, scope 
exceptions require detailed analyses to determine whether they apply in 
particular situations, and consequently, increase the volume of 
accounting literature. For example, the Derivatives Implementation 
Group has issued guidance on twenty implementation issues related to 
the scope exceptions in SFAS No. 133. Further, companies may try to 
justify aggressive accounting by analogizing to scope exceptions, 
rather than more generalized principles.
    Nonetheless, scope exceptions may alleviate complexity in 
situations where the costs of a standard outweigh the benefits. For 
example, many constituents would contend that derivative accounting and 
disclosures for ``normal purchases and normal sales'' contracts are not 
meaningful, and thus, are appropriately excluded from the scope of SFAS 
No. 133.
Discussion
    Subcommittee I preliminarily believes that scope exceptions should 
be minimized to the extent feasible. Possible justifications for 
retaining scope exceptions include: (1) Cost-benefit considerations, 
(2) the need for temporary measures to quickly minimize the effect of 
unacceptable practices, rather than waiting for a final ``perfect'' 
standard to be developed, and (3) the need for temporary measures to 
avoid conflicts in GAAP. However, in cases where scope exceptions are 
provided as a temporary measure, they should be coupled with a long-
term plan by the FASB to eliminate the scope exception through the use 
of sunset provisions.
    Subcommittee I also notes that in certain areas, the SEC staff has 
issued guidance to address transactions that are not within the scope 
of FASB guidance, e.g., literature addressing the balance sheet 
classification of redeemable preferred stock not covered by SFAS No. 
150.\5\ Accordingly, as the FASB develops standards to address these 
transactions, the SEC should eliminate its related guidance.
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    \5\ Accounting for Certain Financial Instruments with 
Characteristics of both Liabilities and Equity.
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    From an international perspective, Subcommittee I notes that IFRS 
currently has fewer scope exceptions than U.S. GAAP. Accordingly, the 
Subcommittee will draft language for the full Committee's 
consideration, which if adopted, would encourage the SEC to affirm the 
IASB's efforts on this path. However, Subcommittee I also notes that, 
in certain circumstances where IFRS includes scope exceptions, they are 
sometimes more expansive than those under U.S. GAAP. For example, IFRS 
3, Business Combinations, scopes out business combinations involving 
entities under common control, which results in no on-point guidance 
for such transactions. Accordingly, Subcommittee I also believes that 
where IFRS provides scope exceptions, the IASB should ensure any 
significant business activities that are excluded from one standard are 
in fact addressed elsewhere. Said differently, the IASB should avoid 
leaving large areas of business activities unaddressed in the 
professional standards.

II.D. Competing Models

    Preliminary Hypothesis 2: GAAP should be based on a presumption 
that similar activities should be accounted for in a similar manner. As 
such, the SEC should recommend that any new projects undertaken jointly 
or separately by the FASB should not create

[[Page 29810]]

additional competing models, except in rare circumstances. Any new 
projects should also include the elimination of competing models in 
relevant areas as a specific objective of these projects, except in 
rare circumstances.
Background
    Competing models are distinguished here from alternative accounting 
policies. Alternative accounting policies, as explained in the Progress 
Report, refer to different accounting treatments that preparers are 
allowed to choose under existing GAAP (e.g., whether to apply the 
direct or indirect method of cash flows). By contrast, competing models 
refer to requirements to apply different accounting models to account 
for similar types of transactions or events, depending on the balance 
sheet or income statement items involved.
    Examples of competing models \6\ include different methods of 
impairment testing for assets such as inventory, goodwill, and deferred 
tax assets.\7\ Other examples include different methods of revenue 
recognition in the absence of a general principle, as well as the 
derecognition of most liabilities (i.e., removal from the balance 
sheet) on the basis of legal extinguishment compared to the 
derecognition of a pension or other post-retirement benefit obligation 
via settlement, curtailment, or negative plan amendment.
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    \6\ Refer to appendix A for additional examples.
    \7\ For instance, inventory is assessed for recoverability 
(i.e., potential loss of usefulness) and remeasured at the lower of 
cost or market value on a periodic basis. To the extent the value of 
inventory recorded on the balance sheet (i.e., its ``cost'') exceeds 
a current market value, a loss is recorded. In contrast, goodwill is 
tested for impairment annually, unless there are indications of loss 
before the next annual test. To determine the amount of any loss, 
the fair value of a ``reporting unit'' (as defined in GAAP) is 
compared to its carrying value on the balance sheet. If fair value 
is greater than carrying value, no impairment exists. If fair value 
is less, then companies are required to allocate the fair value to 
the assets and liabilities in the reporting unit, similar to a 
purchase price allocation in a business combination. Any fair value 
remaining after the allocation represents ``implied'' goodwill. The 
excess of actual goodwill compared to implied goodwill, if any, is 
recorded as a loss. Deferred tax assets are tested for realizability 
on the basis of future expectations. The amount of tax assets is 
reduced if, based on the weight of available evidence, it is more 
likely than not (i.e., greater than 50% probability) that some 
portion or all of the deferred tax asset will not be realized. 
Future realization of a deferred tax asset ultimately depends on the 
existence of sufficient taxable income of the appropriate character 
(e.g., ordinary income or capital gain) within the carryback and 
carryforward periods available under the tax law.
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    Similar to other exceptions to general principles, competing models 
arise for a number of reasons. These include: (1) Scope exceptions, 
which, as discussed above, arise from cost-benefit considerations, 
temporary measures, and political pressure, and (2) the lack of a 
consistent and comprehensive conceptual framework, which results in 
piecemeal standards-setting.
    Competing models contribute to avoidable complexity in that they 
lead to inconsistent accounting for similar activities, and they 
contribute to the volume of accounting literature.
    On the other hand, competing models alleviate avoidable complexity 
to the extent that costs of a certain model exceed the benefits for a 
subset of activities.
Discussion
    Subcommittee I preliminarily believes that similar activities 
should be accounted for in a similar manner. Specifically, Subcommittee 
I acknowledges that competing models may be justified in circumstances 
in which the costs of applying a certain model to a subset of 
activities exceed the benefits. Further, Subcommittee I preliminarily 
believes that competing models may be justified as temporary measures 
(such as when they are temporarily needed to minimize the effect of 
unacceptable practices quickly, rather than waiting for a final 
``perfect'' standard to be developed), as long as they are coupled with 
a sunset provision. To the extent a competing model meets one or more 
of the justifications above, it would not seem objectionable to use 
scope exceptions to clarify which accounting models cover various 
transactions (e.g., standard A ought to refer preparers to standard B 
for transactions excluded from the scope of A).
    Subcommittee I recognizes that the FASB and IASB's joint project on 
the conceptual framework will alleviate some of the competing models in 
GAAP. However, Subcommittee I would encourage the implementation of 
this preliminary hypothesis prior to the completion of conceptual 
framework, where practical, as: (1) The conceptual framework is a long-
term project and (2) current practice issues encountered in the 
standard-setting process will inform the deliberations on the 
conceptual framework.
    Further, as new accounting standards are issued, including that 
which is issued through the convergence process, any competing models 
in related SEC literature should be revised and/or eliminated, as 
appropriate. Subcommittee I notes that, in certain cases, IFRS 
currently has fewer competing models. For example, Subcommittee I notes 
that, unlike U.S. GAAP, the IFRS impairment model is generally 
consistent for tangible assets, intangible assets, and goodwill. As 
such, Subcommittee I will draft language for the full Committee's 
consideration, which if adopted, would encourage the SEC to affirm the 
IASB's efforts on this path, particularly as it works with the FASB on 
the joint conceptual framework.

III. Bright Lines

    Preliminary Hypothesis 3.1: GAAP should be based on a presumption 
that bright lines should not exist. As such, the SEC should recommend 
that any new projects undertaken jointly or separately by the FASB 
avoid the use of bright lines, in favor of proportionate recognition. 
Where proportionate recognition is not feasible or applicable, the FASB 
should provide qualitative factors for the selection of a single 
accounting treatment. Finally, enhanced disclosure should be used as a 
supplement or alternative to the two approaches above.
    Any new projects should also include the elimination of existing 
bright lines in relevant areas to the extent feasible as a specific 
objective of those projects, in favor of the two approaches above.
    Preliminary Hypothesis 3.2: Constituents should be better trained 
to consider the economic substance and business purpose of transactions 
in determining the appropriate accounting, rather than relying on 
mechanical compliance with rules. As such, the SEC should undertake 
efforts, and also encourage the FASB, academics and professional 
organizations, to better educate students, investors, preparers, 
auditors, and regulators in this respect.
Background
    As noted in the Progress Report, bright lines refer to two main 
areas related to financial statement recognition: quantified thresholds 
and pass/fail tests.\8\
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    \8\ Refer to appendix B of the Progress Report for additional 
examples of bright lines.
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    Lease accounting is often cited as an example of bright lines in 
the form of quantified thresholds. Consider, for example, a lessee's 
accounting for a piece of machinery. Under current requirements, the 
lessee will account for the lease in one of two significantly different 
ways: Either (1) reflect an asset and a liability on its balance sheet, 
as if it owns the leased asset, or (2) reflect nothing on its balance 
sheet. The accounting conclusion depends on the results of two 
quantitative tests,\9\ where

[[Page 29811]]

a mere 1% difference in the results of the quantitative tests leads to 
very different accounting.
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    \9\ Specifically, SFAS No. 13, Accounting for Leases, requires 
that leases be classified as capital leases and recognized on the 
lessee's balance sheet where (1) the lease term is greater than or 
equal to 75% of the estimated economic life of the leased property 
or (2) the present value at the beginning of the lease term of the 
minimum lease payments equals or exceeds 90% of the fair value of 
the leased property, among other criteria.
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    The other area of bright lines in this section includes pass/fail 
tests, which are similar to quantitative thresholds because they result 
in recognition on an all-or-nothing basis. However, these types of 
pass/fail tests do not involve quantification. For example, a software 
sales contract may require delivery of four elements. Revenue may, in 
certain circumstances, be recognized as each element is delivered. 
However, if appropriate evidence does not exist to support the 
allocation of the sales price to, for example, the second element, 
software revenue recognition guidance requires that the timing of 
recognition of all revenue be deferred until such evidence exists or 
all four elements are delivered.
    Bright lines arise for a number of reasons. These include a drive 
to enhance comparability across companies by making it more convenient 
for preparers, auditors, and regulators to reduce the amount of effort 
that would otherwise be required in applying judgment (i.e., debating 
potential accounting treatments and documenting an analysis to support 
the final judgment), and the belief that they reduce the chance of 
being second-guessed. Bright lines are also created in response to 
requests for additional guidance on exactly how to apply the underlying 
principle. These requests often arise from concern on the part of 
preparers and auditors of using judgment that may be second-guessed by 
inspectors, regulators, and the trial bar. Finally, bright lines 
reflect efforts to curb abuse by establishing precise rules to avoid 
problems that have occurred in the past.
    Bright lines can contribute to avoidable complexity by making 
financial reports less comparable. This is evident in accounting that 
is not faithful to a transaction's substance, particularly when 
application of the all-or-nothing guidance described above is required. 
Bright lines produce less comparability because two similar 
transactions may be accounted for differently. For example, as 
described above, a mere 1% difference in the quantitative tests 
associated with lease accounting could result in very different 
accounting consequences. Some bright lines also permit structuring 
opportunities to achieve a specific financial reporting result (e.g., 
whole industries have been developed to create structures to work 
around the lease accounting rules). Further, bright lines increase the 
volume of accounting literature as standards-setters and regulators 
attempt to curb abusively structured transactions. The extra literature 
creates demand for additional expertise to account for certain 
transactions. All of these factors add to the total cost of accounting 
and the risk of restatement.
    On the other hand, bright lines may, in some cases, alleviate 
complexity by reducing judgment and limiting aggressive accounting 
policies. They may also enhance perceived uniformity across companies, 
provide convenience as discussed above, and limit the application of 
new accounting guidance to a small group of companies, where no 
underlying standard exists. In these situations, the issuance of 
narrowly-scoped guidance may allow for issues to be addressed on a more 
timely basis. In other words, narrowly-scoped guidance and the bright 
lines that accompany them may function as a short-term fix on the road 
to ideal accounting.
Discussion
    Subcommittee I preliminarily believes that bright lines in GAAP 
should be minimized in favor of proportionate recognition. As a 
secondary approach, where proportionate recognition is not feasible or 
applicable, the Subcommittee recommends that GAAP be based on 
qualitative factors, supported by presumptions \10\ as necessary. 
Subcommittee I also preliminarily believes that disclosure may be used 
as a supplement or alternative to the approaches above.
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    \10\ In order for the use of presumptions to be meaningful and 
consistently applied, Subcommittee I preliminarily believes that the 
FASB should adopt consistent use of terms describing likelihood 
(e.g., rare, remote, reasonably possible, more likely than not, 
probable), time frames (e.g., contemporaneous, immediate, imminent, 
near term, reasonable period of time), and magnitude (e.g., 
insignificant, material, significant, severe).
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    Subcommittee I uses the term ``proportionate recognition'' to 
describe accounting for the rights and obligations in a contract. In 
contrast to the current all-or-nothing recognition approach in GAAP, 
Subcommittee I preliminarily believes that accounting for rights and 
obligations would be appropriate in areas such as lease accounting--in 
effect, an entity would fully recognize its rights to use an asset, 
rather than the physical asset itself. In these cases, regardless of 
whether the lease is considered to be operating or capital (based on 
today's dichotomy), all entities would record amounts in the financial 
statements to the extent of their involvement in the related business 
activities. For example, consider a lease in which the lessee has the 
right to use a machine, valued at $100, for four years. Also assume 
that the machine has a 10-year useful life. Under proportionate 
recognition, a lessee would recognize an asset for its right to use the 
machine (rather than for a proportion of the asset) at approximately 
$35 \11\ on its balance sheet. Under the current accounting literature, 
the lessee would either recognize the machine at $100 or recognize 
nothing on its balance sheet, depending on the results of certain 
bright line tests. Similarly, this rights-and-obligations approach may 
also be relevant in the context of revenue recognition, in particular, 
in comparison to today's software revenue recognition model.
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    \11\ For purposes of illustration, $35 represents a company's 
net present value calculations. The example is only intended to be 
illustrative and is not prescriptive. The basis of proportionate 
recognition may be an asset's estimated useful life, its future cash 
flows or some other approach depending on the facts and 
circumstances.
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    However, Subcommittee I recognizes that proportionate recognition 
is not universally applicable. For example, proportionate recognition 
is not applicable in situations where the economics of a transaction 
legitimately represent an all-or-nothing scenario.\12\ In situations 
like these, the FASB should consider providing qualitative factors, 
supported by presumptions, to guide the selection of a single 
appropriate accounting treatment by preparers. Subcommittee I 
preliminarily believes qualitative factors, including presumptions, 
would promote the application of principles over compliance with rules, 
while still narrowing the range of interpretation in practice to 
facilitate comparability across companies. Admittedly, presumptions may 
result in all-or-nothing accounting, but differ from bright lines 
because they are not arbitrary or determinative in their own right.
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    \12\ Examples include determining (1) whether a contract should 
be accounted for as a single unit of account or whether it should be 
split into multiple components, and (2) whether a contract that has 
characteristics of both liabilities and equity should be treated as 
one instead of the other.
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    Subcommittee I uses the term ``presumptions'' to describe a method 
by which an accounting conclusion may be initially favored (i.e., not 
stringently applied), subject to the consideration of additional 
factors. This approach is used to some extent today. For instance, the 
business combination literature contains an example of a presumption

[[Page 29812]]

coupled with additional considerations.\13\ There are situations in 
which selling shareholders of a target company are hired as employees 
by the purchaser because the purchaser may wish to retain the sellers' 
business expertise. The payments to the selling shareholders may either 
be treated as: (1) Part of the cost of the acquisition, which means the 
payments are allocated to certain accounts on the purchaser's balance 
sheet, such as goodwill, or (2) compensation to the newly-hired 
employees, which are recorded as an expense in the purchaser's income 
statement, reducing net income. Some of these payments may be 
contingent on the selling shareholders' continued employment with the 
purchaser, e.g., the individual must still be employed three years 
after the acquisition in order to maximize the total sales price. GAAP 
provides several factors to consider when deciding whether these 
payments should be treated as an expense or not, but establishes a 
presumption that any future payments linked to continued employment 
should be treated as an expense. It is possible this presumption may be 
overcome depending on the circumstances.
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    \13\ Emerging Issues Task Force (EITF) 95-8, Accounting for 
Contingent Consideration Paid to the Shareholders of an Acquired 
Enterprise in a Purchase Business Combination. Subcommittee I notes 
EITF 95-8 is nullified by a new FASB standard, SFAS No. 141 (revised 
2007), Business Combinations. SFAS No. 141 (revised 2007) states ``A 
contingent consideration arrangement in which the payments are 
automatically forfeited if employment terminates is compensation * * 
*'' However, the guidance in EITF 95-8 is still helpful in 
describing our approach with respect to the use of presumptions 
coupled with additional considerations in GAAP.
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    Finally, Subcommittee I notes that disclosure is critical to 
communicating with users, either by supplementing financial statement 
recognition (proportionate or otherwise) or by discussing events and 
uncertainties outside of the financial statements. Subcommittee I 
preliminarily believes that in some cases, disclosure may be more 
informative than recognition, as point estimates recognized in 
financial statements may provide a misleading sense of precision. 
Subcommittee I discusses examples of this situation in its 
consideration of a disclosure framework (section V of this report).
    In order for these preliminary hypotheses to be operational, 
Subcommittee I recognizes the need for a cultural shift towards the 
acceptance of more judgment. In this regard, Subcommittee I 
preliminarily believes that professional judgment framework discussed 
in developed proposal 3.4 is critical to the success of these 
preliminary hypotheses. Subcommittee I further notes that even if the 
FASB limits its use of bright lines, other parties may continue to 
create similar non-authoritative guidance, which may proliferate the 
use of bright lines. As such, Subcommittee I preliminarily believes 
that developed proposal 2.4 regarding the reduction of parties that 
formally or informally interpret GAAP is helpful.
    From an international perspective, Subcommittee I notes that IFRS 
currently has fewer bright lines than U.S. GAAP. Consequently, 
Subcommittee I will draft language for the full Committee's 
consideration, which if adopted, would encourage the SEC to affirm the 
IASB's efforts on this path.
    With respect to training and educational efforts, Subcommittee I 
notes the U.S. Treasury Department's Advisory Committee on the Auditing 
Profession has offered a number of preliminary recommendations on this 
topic. The Subcommittee is generally supportive of their direction, and 
will draft language for the full Committee's consideration, which if 
adopted, would encourage the SEC to monitor these developments as it 
takes steps, in coordination with the FASB, to promote the ongoing 
education of all financial reporting constituents.

IV. Mixed Attribute Model

    As previously noted in the Progress Report, the mixed attribute 
model is one in which the carrying amounts of some assets and 
liabilities are measured at historic cost, others at lower of cost or 
market, and still others at fair value. There are several measurement 
attributes that currently exist in GAAP, all of which result in 
combinations and subtotals of amounts that are not intuitively useful. 
This complexity is compounded by requirements to record some 
adjustments in earnings, while others are recorded in equity (i.e., 
comprehensive income). For example, changes in the fair value of a 
derivative may be charged directly to equity, while an asset's current 
period depreciation expense reduces net income.
    Optimally, the FASB should develop a consistent approach to 
determine which measurement attribute should apply to different types 
of business activities. While Subcommittee I is aware the FASB has a 
long-term project to develop such an approach, known as the measurement 
framework, it advocates three steps in the near term for the 
Committee's consideration to improve the clarity of financial 
statements for investors.
    First, the Committee should advise caution about expanding the use 
of fair value in financial reporting until a number of practice issues 
are better understood and resolved, providing time for the FASB to 
complete its measurement framework. Second, the Committee should 
recommend a presentation of distinct measurement attributes on the face 
of the primary financial statements, grouped by business activities. 
This will make subtotals of individual line items in the statements 
more meaningful. Third, the Committee should propose the development of 
a disclosure framework, which would enable users to better understand 
the key risks and uncertainties associated with different measurement 
attributes (refer to section V below).
    Preliminary Hypothesis 4: Avoidable complexity caused by the mixed 
attribute model should be reduced in three respects:
     Measurement framework--The SEC should recommend that the 
FASB be judicious in issuing new standards and interpretations that 
expand the use of fair value in areas where it is not already 
required,\14\ until completion of a measurement framework. The SEC 
should also recommend that, to the maximum extent feasible, the FASB 
use a single measurement attribute for each type of business activity 
presented in the financial statements.\15\
---------------------------------------------------------------------------

    \14\ For instance, improvements to certain existing, 
particularly complex standards, such as SFAS No. 133, Accounting for 
Derivatives and Hedging Activities and SFAS No. 140, Accounting for 
Transfers and Servicing of Financial Assets and Extinguishments of 
Liabilities, may be warranted in the near term.
    \15\ To make this approach operational, the FASB might establish 
a rebuttable presumption in favor of a single measurement attribute 
within each business activity (i.e., operating, investing and 
financing). For example, the Board may determine amortized cost is 
the presumptive measurement attribute within the operating section 
of a company's financial statements. Nevertheless, the Board would 
also have to consider whether fair value is appropriate for 
financial assets and liabilities employed in those business 
activities, such as certain derivative contracts used to hedge 
commodity price risk for materials used in the production process.
---------------------------------------------------------------------------

     Financial statement presentation--The SEC should encourage 
the FASB to:
    [cir] Assign a single measurement attribute within each business 
activity that is consistent across the financial statements.
    [cir] Aggregate business activities into operating, investing and 
financing sections.\16\
---------------------------------------------------------------------------

    \16\ Subcommittee I is aware of the FASB and IASB's joint 
financial statement presentation project and is generally supportive 
of its direction. Subcommittee I also notes that in addition to the 
three business activities listed here, the FASB's project 
contemplates two additional types of business activities--income 
taxes and discontinued operations.

---------------------------------------------------------------------------

[[Page 29813]]

    [cir] Add a new primary financial statement to reconcile the 
statements of income and cash flows by measurement attribute.\17\
---------------------------------------------------------------------------

    \17\ An example of this presentation is included below.
---------------------------------------------------------------------------

     Enhanced disclosure--refer to section V of this report.
Background
    As the Committee noted in the Progress Report, examples of 
accounting standards that result in mixed attribute measurement include 
two FASB standards related to financial instruments. SFAS No. 159, The 
Fair Value Option for Financial Assets and Financial Liabilities, 
permits the fair valuation of certain assets and liabilities. As a 
result, some assets and liabilities are measured at fair value, while 
others are measured at amortized cost or some other basis. SFAS No. 
115, Accounting for Certain Investments in Debt and Equity Securities, 
requires certain investments to be recognized at fair value and others 
at amortized cost.
    In practice, the costs associated with (potentially uncertain) fair 
value estimates can be considerable. Some preparers' knowledge of 
valuation methodology is limited, requiring the use of valuation 
specialists. Auditors often require valuation specialists of their own 
to support the audit. Some view the need for these valuation 
specialists as a duplication of efforts, at the expense of the 
preparer. In addition, there are recurring concerns about second-
guessing by auditors, regulators, and courts in light of the many 
judgments and imprecision involved with fair value estimates. 
Regardless of whether such estimates are prepared internally or by 
valuation specialists, the effort and elapsed time required to 
implement and maintain mark-to-model fair values is significant. For 
these reasons, preparers and auditors will likely have to incur costs 
to broaden their proficiency in basic valuation matters,\18\ and 
additional education may be required for the larger financial reporting 
community to become further accustomed to fair value information.
---------------------------------------------------------------------------

    \18\ For instance, additional training for field auditors may be 
necessary to lessen dependency on valuation experts.
---------------------------------------------------------------------------

    Nevertheless, some have advocated mandatory and comprehensive use 
of fair value as a solution to the complexities arising from the mixed 
attribute model. However, opponents argue that this would only shift 
the burden of complexity from investors to preparers and auditors, 
among others. Specifically, certain investors may find uniform fair 
value reporting simpler and more meaningful than the current mixed 
attribute model. But under a full fair value approach, some objectivity 
would be sacrificed because many amounts that would change to fair 
value are currently reported on a more verifiable basis, such as 
historic cost. These amounts would have to be estimated by preparers 
and certified by auditors, as discussed above. Such estimates are made 
even more subjective by the lack of a single set of generally accepted 
valuation standards and the use of inputs to valuation models that vary 
from one company to the next. Likewise, significant variance exists in 
the quality, skill, and reports of valuation specialists, which 
preparers have limited ability to assess. Finally, there is no 
mechanism to ensure the ongoing quality, training, and oversight of 
valuation specialists. As a result, some believe a wholesale transition 
to fair value would reduce the reliability of financial reports to an 
unacceptable degree.
    Therefore, as the Committee noted in its Progress Report, 
Subcommittee I assumes that a complete move to fair value is most 
unlikely. Within this context, the partial use of fair value increases 
the volume of accounting literature. Said differently, when more than 
one measurement attribute is used, guidance is required for each one. 
In addition, some entities may operate under the impression that 
investors are averse to market-driven volatility. Consequently, 
entities have demanded exceptions from the use of fair value in 
financial reporting, resisted its use, and/or entered into transactions 
that they otherwise would not have undertaken to artificially limit 
earnings volatility. These actions have resulted in a build up in the 
volume of accounting literature. More generally, some believe that 
attempts by companies to smooth amounts that are not smooth in their 
underlying economics reduce the efficiency and the effectiveness of 
capital markets.
    With respect to users, information delivery is made more difficult 
by fair value. Investors may not understand the uncertainty associated 
with fair value measurements (i.e., that they are merely estimates and, 
in many instances, lack precision), including the quality of unrealized 
gains and losses in earnings that arise from changes in fair value. 
Some question whether the use of fair value may lead to 
counterintuitive results. For example, an entity that opts to fair 
value its debt may recognize a gain when its credit rating declines. 
Others question whether the use of fair value for held to maturity 
investments is meaningful. Finally, preparers may view disclosure of 
some of the inputs to the assumptions as sensitive and competitively 
harmful.
    Despite these difficulties, the use of fair value may alleviate 
some aspects of avoidable complexity. Such information may provide 
investors with management's perspective, to the extent management makes 
decisions based on fair value, and it may improve the relevance of 
information in many cases, as historical cost is not meaningful for 
certain items.
    Fair value may also enhance consistency by reducing confusion 
related to measurement mismatches. For example, an entity may enter 
into a derivative instrument to hedge its exposure to changes in the 
fair value of debt attributable to changes in the benchmark interest 
rate. The derivative instrument is required to be recognized at fair 
value, but, assuming no application of hedge accounting or the fair 
value option, the debt would be measured at amortized cost, resulting 
in measurement mismatches. In addition, fair value might mitigate the 
need for detailed application guidance explaining which instruments 
must be recorded at fair value and help prevent some transaction 
structuring. Specifically, if fair value were consistently required for 
all similar activities, entities would not be able to structure a 
transaction to achieve a desired measurement attribute.
    Fair value also eliminates issues surrounding management's intent. 
For example, entities are required to evaluate whether investments are 
impaired. Under certain impairment models, entities are currently 
required to assess whether they have the intent and ability to hold the 
investment for a period of time sufficient to allow for any anticipated 
recovery in market value. As the Committee noted in the Progress Report 
(see discussion supporting developed proposal 1.2 to minimize 
alternative accounting policies) management intent is subjective and, 
thus, less auditable. However, use of fair value would generally make 
management intent irrelevant in assessing the value of an investment.
Discussion
    Subcommittee I acknowledges the view that a complete transition to 
fair value would alleviate avoidable complexity resulting from the 
mixed attribute model. However, Subcommittee I also recognizes that 
expanded use of fair value would increase avoidable complexity unless 
numerous implementation questions related to relevance and reliability 
are

[[Page 29814]]

addressed (as discussed above), which extend beyond the scope of our 
work.
    Therefore, consistent with current practice, Subcommittee I 
preliminarily believes fair value should not be the only measurement 
attribute in GAAP. At present, Subcommittee I believes the Committee 
should advise caution about expanding the use of fair value until a 
systematic measurement framework is developed, and in this regard, that 
phase two of the FASB's fair value option project, which will consider 
permitting fair value measurement for certain nonfinancial assets and 
liabilities, should not be finalized prior to completion of a 
measurement framework.\19\
---------------------------------------------------------------------------

    \19\ Similarly, Subcommittee I preliminarily believes the 
Committee should recommend that the FASB consider deferring 
provisions of new standards that are issued, but not yet effective, 
which expand the use of fair value measurement where it has not been 
previously required.
---------------------------------------------------------------------------

    At that point, the FASB should determine measurement attributes 
based on considerations such as business activity, the relevance and 
reliability of fair value inputs, and other considerations vetted 
during the measurement phase of its conceptual framework project. While 
Subcommittee I prefers an activity-based approach to assigning 
measurement attributes, Subcommittee I is sympathetic to an approach 
based on the type of asset or liability in question, such as financial 
instruments vs. non-financial instruments. This is a natural tension 
that the FASB should address as part of the measurement framework. For 
example, in one scenario, the Board may determine amortized cost is the 
presumptive measurement attribute within the operating section of a 
company's financial statements. Nevertheless, the Board would also have 
to consider whether fair value is appropriate for financial assets and 
liabilities employed in those business activities such as certain 
derivative contracts used to hedge commodity price risk for materials 
used in the production process.
    With respect to financial statement presentation, Subcommittee I 
preliminarily believes the grouping of individual line items (and 
related measurement attributes) by operating, investing and financing 
activities would alleviate some of the concerns about fair value in 
particular. It would also reduce confusion caused by the commingling of 
all measurement attributes. Subcommittee I preliminarily believes this 
presentation would be more understandable to investors, particularly 
because it would delineate the nature of changes in income (e.g., fair 
value volatility, changes in estimate) and allow users to assess the 
degree to which management controls each one.
    It may also facilitate earnings analyses by business activities 
that correspond to the natural elements of most profit-driven entities, 
for instance, operating income compared to investing or financing 
results. Under this approach, companies should present earnings per-
share computations of the net activity in each section. Further, the 
addition of a new primary financial statement--the reconciliation of 
the statements of comprehensive income and cash flows--would 
disaggregate changes in assets and liabilities based on cash, accruals, 
and changes in fair value, among others. A visual example of this 
statement might include the following: \20\
---------------------------------------------------------------------------

    \20\ Subcommittee I has adapted and modified this table from a 
similar schedule in the FASB's financial statement presentation 
project.

                                                Reconciliation of the Statements of Income and Cash Flows
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                    Non-cash items affecting income
                                                         ----------------------------------------------------
                                              Cash flow    Cash flows    Accruals                                Income
                                              statement       not          and       Recurring      Other      statement
                                                           affecting    systematic   valuation    valuation   (A+B+C+D+E)
                                                             income    allocations    changes      changes
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                       A            B            C            D            E            F
--------------------------------------------------------------------------------------------------------------------------------------------------------
Operating:
    Cash received from sales...............
                                               2,700,000  ...........       75,000  ...........  ...........    2,775,000  Sales.
                                                       0  ...........      (9,000)  ...........  ...........      (9,000)  Depreciation expense.
                                                       0  ...........  ...........  ...........     (15,000)     (15,000)  Impairment expense.
                                                       0  ...........  ...........      (7,500)  ...........      (7,500)  Forward contract adj.
Investing:
    Capital expenditures...................    (500,000)      500,000  ...........  ...........  ...........            0  .............................
    Sale of available for sale securities..        5,000      (4,900)  ...........          350  ...........          450  Realized gain on sale.
Financing:
    Interest paid..........................    (125,000)  ...........    (100,000)  ...........  ...........    (225,000)  Interest expense.
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Subcommittee I preliminarily believes that the correlation of rows 
and columns in this schedule will help users assess different elements 
of financial performance, e.g., sales is comprised primarily of cash 
receipts, but also end of period accruals. Recognizing companies will 
use different titles for income statement line items, Subcommittee I 
preliminarily believes the predominant value of this schedule is the 
columnar depiction of measurement attributes and the context it 
provides for earnings analysis. For example, users should be better 
equipped to form opinions about a company's earnings quality and the 
predictability of its future cash flows because they are generally 
unable to prepare similar reconciliations based on today's financial 
statements. While this revised presentation does not resolve all of the 
challenges posed by the mixed attribute model, it represents an 
improvement over the current approach for investors to understand a 
company's financial condition and operating results.
    From an international perspective Subcommittee I notes the mixed 
attribute model also exists under IFRS. As such, Subcommittee I 
preliminarily believes that this preliminary hypothesis applies equally 
to IFRS, particularly as the IASB works with the

[[Page 29815]]

FASB on the joint financial statement presentation project.

V. Disclosure Framework

    Disclosure provides important context for the estimates and 
judgments reflected in the financial statements. It also highlights 
uncertainties outside of the statements that could impact financial 
performance in the future.
    Subcommittee I preliminarily believes that any recommendations 
regarding new disclosure guidance will be most effective and 
informative for investors if the FASB and SEC update, or as necessary, 
rescind outdated or duplicative disclosure requirements. Subcommittee 
I's preliminary hypothesis advocates establishing a process to achieve 
this goal.
    Preliminary Hypothesis 5: The SEC should request the FASB to 
develop a disclosure framework to:
     Require disclosure of the principal assumptions, estimates 
and sensitivity analyses that may impact a company's business, as well 
as 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 certain litigation and regulatory developments.
     Integrate existing disclosure requirements into a cohesive 
whole by eliminating redundant disclosures and providing a single 
source of disclosure guidance across all accounting standards.
    The SEC and FASB should also establish a process of coordination 
for the Commission to regularly update and, as appropriate, remove 
portions of its disclosure requirements as new FASB standards are 
issued.\21\
---------------------------------------------------------------------------

    \21\ The Committee considers coordination between the SEC and 
the FASB in chapter 2 of the Progress Report, particularly 
conceptual approaches 2.A and 2.C.
---------------------------------------------------------------------------

Background
    Historically, disclosure standards have developed in a piecemeal 
manner (i.e., standard-by-standard). The lack of an underlying 
framework has contributed to (1) Repetitive disclosures, (2) 
excessively detailed disclosures that may confuse rather than inform, 
and (3) disorganized presentations in financial reports. These factors 
make fulsome and meaningful communication of all material information 
challenging.
    As noted above, disclosure provides important context for the 
estimates and judgments reflected in the financial statements. However, 
Subcommittee I acknowledges the perception that amounts recognized in 
financial statements are generally subject to more refined calculations 
by preparers and higher degrees of scrutiny by users compared to mere 
disclosure. As a result, the effectiveness of disclosure standards--
whether existing or new--will be governed by the degree to which 
constituents view them as another compliance exercise rather than an 
avenue for meaningful dialogue.
    Subcommittee I preliminarily believes that a disclosure framework 
would facilitate this meaningful dialogue between preparers and users. 
In order for such a disclosure framework to be useful over the long-
run, however, it should establish objectives, whose application will 
vary. Otherwise, disclosure standards will degenerate into myriad rules 
because it is not feasible for standards-setters to envision all of the 
specific future disclosure requirements that would be necessary in 
different settings.
    For example, in the wake of the recent ``liquidity crisis,'' there 
has been significant focus on disclosures related to off-balance-sheet 
entities. Of particular interest is disclosure of structured investment 
vehicles (SIVs).\22\ Recently, certain sponsoring banks have provided 
liquidity support to SIVs that were unable to sustain financing in the 
short-term commercial paper market. In some cases, this led the 
sponsors to consolidate the SIVs under FASB Interpretation No. 46(R), 
which added billions of dollars of assets and liabilities to the 
sponsors' balance sheets. Consequently, some constituents have 
criticized existing disclosure practices and called for standards-
setters to require additional ``early warning'' disclosure about off-
balance sheet activity (e.g., types of assets held by the SIVs, 
circumstances that may result in consolidation or loss, and 
methodologies used to determine fair value and related write-downs). 
Others counter that: (1) Major SIV sponsors already disclosed the 
magnitude of their investments in off-balance sheet entities prior to 
the liquidity crisis and (2) further detail would have been 
uninformative and potentially confusing to users because it would have 
amounted to ``disclosure overload.'' For instance, at the time the 
decision not to consolidate was reached, some sponsors may have 
concluded it was quite unlikely that events which might lead to 
consolidation would actually occur, and that discussion of these 
scenarios was unnecessary. These two opposing points of view highlight 
the tension noted above, namely, that some constituents prefer 
detailed, prescriptive disclosure guidance, while others favor a more 
principled approach.
---------------------------------------------------------------------------

    \22\ From a review of SEC filed documents, Subcommittee I has 
identified seven SEC filers that sponsored SIVs around the time of 
the liquidity crisis. Prior to the crisis, most of these filers did 
not provide quantified disclosure of the unconsolidated SIVs' assets 
and liabilities (in some cases, SIV assets and liabilities were 
aggregated with the assets and liabilities of other off-balance 
sheet arrangements--collectively, ``VIEs''). Subsequent to the 
crisis, Subcommittee I notes that some sponsors have expanded their 
disclosures to include additional quantitative information, as well 
as qualitative disclosures such as the nature of SIV assets, 
descriptions of SIV investment and operating strategies, risks 
related to the current environment, and sponsors' obligations to the 
SIVs.
---------------------------------------------------------------------------

Discussion
    Specifically, Subcommittee I preliminarily believes that at a 
minimum, an effective disclosure framework is comprised of three basic 
elements: (1) A description of the transactions reflected in financial 
statement captions, (2) a discussion of the relevant accounting 
provisions, and (3) an analysis of the key supporting judgments, risks 
and uncertainties.\23\ In the following commentary, we focus largely on 
the third element.
---------------------------------------------------------------------------

    \23\ Subcommittee I acknowledges the work of the FASB's 
Investors Technical Advisory Committee on the topic of a disclosure 
framework. Subcommittee I preliminarily agrees with the need to 
establish a principles-based approach to future disclosure standards 
and has adapted certain elements of ITAC's thinking in this 
discussion.
---------------------------------------------------------------------------

    Within the financial statements, a disclosure framework should more 
effectively signal to investors the level of imprecision associated 
with significant estimates and assumptions, particularly some fair 
value measurements. This can be achieved by disclosing the principal 
assumptions, estimates and sensitivity analyses that impact a company's 
business, as well as a qualitative discussion of the key risks and 
uncertainties that could significantly change these amounts over time. 
For example, Subcommittee I notes that in certain cases, there is no 
``right'' number in a probability distribution of figures, some of 
which may be more fairly representative of fair value than others. 
While SFAS No. 157, Fair Value Measurements, established disclosure 
requirements that provide insight into Level 2 and 3 fair value 
estimates,\24\ it may not be sufficient in all cases. Many investors 
might find information about the key assumptions in a valuation model, 
key risks

[[Page 29816]]

associated with those assumptions,\25\ and related sensitivity analyses 
helpful, as well as an understanding of how ``fat'' or ``thin'' the 
tails of statistical modeling techniques are.\26\
---------------------------------------------------------------------------

    \24\ Statement 157 established a three level fair value 
hierarchy. It assigns highest priority to quoted prices in active 
markets (Level 1) and the lowest priority to unobservable inputs 
that rely heavily on assumptions (Level 3).
    \25\ For example, if a valuation model relies on historical 
assumptions for a period of time that does not include economic 
downturns, that fact and its implications may need to be disclosed.
    \26\ In statistics, this notion is known as the ``goodness of 
fit,'' which describes how well a statistical model fits a set of 
observations. These are quantified measures that summarize the 
discrepancy between observed values compared to values predicted by 
the model. Large discrepancies can be described as ``fat,'' while 
small discrepancies are ``thin.''
---------------------------------------------------------------------------

    Outside of the financial statements, disclosure of environmental 
factors may be more meaningful than attempting to ``force'' a wide 
range of probabilities into a single point estimate on the balance 
sheet or income statement. This would encompass events and 
uncertainties such as relevant market conditions, off-balance sheet 
activity, litigation and regulatory developments. Some constituents 
argue that recording an estimate to reflect these events, instead of 
disclosing them, may actually provide a misleading sense of precision. 
Alternatively, they suggest companies could communicate to investors 
more effectively by disclosing the factors that might trigger financial 
statement recognition, the magnitude of possible and/or probable 
transactions, and management's plans in those scenarios.
    In any event, Subcommittee I acknowledges some disclosure guidance 
establishes a ``floor'' for communication between companies and 
investors, rather than a ``ceiling.'' \27\ Our preliminary hypothesis 
offers a more cohesive structure for the narrative that supports and 
explains the financial statements, but Subcommittee I believes 
preparers should take the initiative in tailoring financial reports for 
users.
---------------------------------------------------------------------------

    \27\ Subcommittee I notes companies are not precluded from 
providing disclosure of the type proposed here. Indeed, certain 
existing guidance is largely consistent with our views, such as APB 
Opinion No. 22, Disclosure of Accounting Policies, SOP No. 94-6, 
Disclosure of Certain Significant Risks and Uncertainties, Item 
303(a) of Regulation S-K related to Management's Discussion and 
Analysis, and FRR 60, Cautionary Advice Regarding Disclosure About 
Critical Accounting Policies.
---------------------------------------------------------------------------

    Subcommittee I also recognizes the proposed disclosure framework 
incorporates factual information that, historically, is presented in 
audited footnotes, as well as analytical and forward-looking 
discussions that are typically part of MD&A narratives in SEC filings. 
Subcommittee I acknowledges that there are important considerations 
regarding assurance and legal issues when determining the placement of 
disclosures in a filing (e.g., footnotes or MD&A). Therefore, an 
optimally designed disclosure framework should be developed by the FASB 
under close coordination with the SEC so that the Commission can amend 
its guidance accordingly (e.g., Regulations S-K and S-X).
    Beyond these concerns, the SEC or its staff should also update, and 
as needed remove, portions of public company disclosure guidance that 
are impacted by new FASB standards. Subcommittee I is aware of studies 
in the past conducted to identify overlaps of this type.\28\ Unless the 
SEC or its staff establishes a monitoring process to update its 
disclosure requirements, similar studies may be necessary in the 
future. Additionally, if developed proposal 1.1 to minimize industry-
specific accounting guidance is adopted, the SEC or its staff may need 
to consider revising its Industry Guides in Items 801 and 802 of 
Regulation S-K.
---------------------------------------------------------------------------

    \28\ In particular, the 2001 FASB report on ``GAAP-SEC 
Disclosure Requirements,'' which was a part of a larger Business 
Reporting Research Project.
---------------------------------------------------------------------------

    From an international perspective, Subcommittee I notes that IAS 1, 
Presentation of Financial Statements, includes some of the elements 
that Subcommittee I would expect of a disclosure framework, such as a 
principle for: (1) What the notes to the financial statements should 
disclose, (2) footnote structure. (3) disclosures of judgments, and (4) 
disclosures of key sources of estimation or uncertainty, including 
sensitivity analyses. Nonetheless, Subcommittee I preliminarily 
believes that its preliminary hypothesis in this area would also result 
in improvements to IFRS.

Appendix A

1. Scope Exceptions

    Examples of scope exceptions include:
     SFAS No. 109, Accounting for Income Taxes, scopes out 
recognition of deferred taxes for undistributed earnings of certain 
subsidiaries and for goodwill for which amortization is not deductible, 
among others.
     SFAS No. 133, Accounting for Derivative Instruments and 
Hedging Activities, scopes out certain financial guarantee contracts, 
employee share-based payments, and contingent consideration from a 
business combination, among others.
     SFAS No. 144, Accounting for the Impairment or Disposal of 
Long-Lived Assets, scopes out goodwill, intangible assets not being 
amortized that are to be held and used, financial instruments, 
including cost and equity method investments, and deferred tax assets, 
among others.
     SFAS No. 157, Fair Value Measurements, scopes out its 
definition of fair value for guidance related to employee share-based 
payments and lease classification and measurement, among others. In 
addition, they delay in the adoption of SFAS No. 157 for nonfinancial 
assets and nonfinancial liabilities, except for items that are 
recognized or disclosed at fair value in the financial statements on a 
recurring basis (at least annually), effectively scoping out these 
items for a period of time.
     FIN 45, Guarantor's Accounting and Disclosure Requirements 
for Guarantees, Including Indirect Guarantees of Indebtedness to 
Others, scopes out contracts that have the characteristics of 
guarantees, but (1) are accounted for as contingent rent under SFAS No. 
13 and (2) provide for payments that constitute vendor rebates (by the 
guarantor) based on either the sales revenues of, or the number of 
units sold by, the guaranteed party, among others.
     FIN 46R, Consolidation of Variable Interest Entities, 
scopes out employee benefit plans, qualifying special-purpose entities, 
certain entities for which the company is unable to obtain the 
information necessary to apply FIN 46R, and certain businesses, among 
others.
     SoP 81-1, Accounting for Performance of Construction/
Production Contracts, scopes out certain sales of manufactured goods, 
even if produced to buyers' specifications, and service contracts of 
consumer-oriented organizations that provide their services to their 
clients over an extended period, among others.

2. Competing Models

    Examples of competing models include:
     Different models for when to recognize for impairment of 
assets such as inventory, goodwill, long-lived assets, financial 
instruments, and deferred taxes.
     Different likelihood thresholds for recognizing contingent 
liabilities, such as probable for legal uncertainties versus more-
likely-than-not for tax uncertainties.
     Different models for revenue recognition such as 
percentage of completion, completed contract, and pro-rata. Models also 
vary based on the nature of the industry involved, as discussed in 
other sections.
     Derecognition of most liabilities such as on the basis of 
legal extinguishment, as compared to the

[[Page 29817]]

derecognition of pension and other post-retirement benefit obligations 
via settlement, curtailment, or negative plan amendment.
     Different models for determining whether an arrangement is 
a liability or equity.

Exhibit B

SEC Advisory Committee on Improvements to Financial Reporting

Standards-Setting Subcommittee Update

May 2, 2008 Full Committee Meeting

I. Introduction

    The SEC's Advisory Committee on Improvements to Financial Reporting 
(the Committee) issued a Progress Report (the Progress Report) on 
February 14, 2008. In chapter 2 of the Progress Report, the Committee 
discussed its work to date on the standards-setting process, namely 
its:
     Developed proposals related to increased investor 
participation, FAF and FASB governance, standards-setting process 
improvements and interpretive implementation guidance;
     Conceptual approaches regarding clarifying the SEC's role 
in standards-setting, design of standards and the FASB's priorities; 
and
     Future considerations related to international governance.
    Since the issuance of the Progress Report, the standards-setting 
subcommittee (Subcommittee II) has deliberated each of these areas 
further, particularly its conceptual approaches and future 
considerations and is in the process of refining them accordingly. This 
report presents a summary of Subcommittee II's latest thinking and 
serves as an update to the Committee. The Committee is also hosting 
panel discussions on May 2, 2008, in Rosemont, IL. Subcommittee II will 
re-deliberate each of these topics based on testimony received, 
guidance to be provided by the Committee and comment letters received 
thus far by the Committee. The Committee will deliberate any new 
proposals and proposed revisions to existing developed proposals in 
July 2008.

II. Current Status and Further Work

International Considerations

    The Committee deferred deliberation of international considerations 
until 2008. Subcommittee II acknowledges that the SEC has already 
received significant input associated with its (1) removal of the U.S. 
GAAP reconciliation for foreign private issuers reporting under IFRS as 
promulgated by the IASB and (2) concept release on the possibility of 
allowing domestic issuers to report under IFRS as promulgated by the 
IASB. Subcommittee II also observes that debates regarding both the end 
state of international convergence (that is, a single set of high 
quality global accounting standards) and the best way to accomplish 
that objective in the U.S. (that is, the transition) are underway among 
standards-setters, their governance bodies, the international 
regulatory community and others. After discussion with the SEC staff 
and in light of these ongoing deliberations, which include SEC staff 
consideration of comments received in response to the concept release, 
input from roundtables, and the staff's work on developing a roadmap 
for consideration by the Commission at the request of Chairman Cox, 
Subcommittee II does not intend to advance detailed proposals at this 
time.
    Although an analysis of how the international standards-setting 
processes could be improved was not in the Committee's mandate, 
Subcommittee II believes that many of the Committee's developed 
proposals and conceptual approaches may be equally applicable in 
international standards-setting. Subcommittee II also noted that an 
important U.S. convergence question has not been openly debated in the 
public forum--how the SEC will fulfill its regulatory responsibility 
without creating a U.S. jurisdictional variant of IFRS.
    Although not intending to recommend detailed proposals, 
Subcommittee II is deliberating whether the Committee should consider:
     Expressing high-level support for moving to a single set 
of high quality accounting standards in the U.S.,
     supporting the SEC's efforts to develop an international 
convergence roadmap, and
     encouraging all participants in the financial reporting 
community to increase coordination to foster consistency in global 
interpretations and avoid jurisdictional variants of IFRS.
    The final determination of whether Subcommittee II's deliberations 
will result in a developed proposal will not be known until later in 
2008.

FASB Dialogue

    Since the Committee issued its Progress Report, Subcommittee II has 
engaged representatives of the FASB in a dialogue regarding the 
Committee's developed proposals and conceptual approaches. As a result 
of this dialogue, as well as the public comments received on the 
Progress Report, Subcommittee II is currently deliberating potential 
modifications to the Committee's proposal for Committee deliberation as 
its final recommendations.
    A number of tentative modifications are being contemplated, which 
are summarized as follows:
     International--The Committee's proposals assume that U.S. 
GAAP will continue to be in use for a number of years. However, 
convergence matters significantly drive priorities in standards-
setting. Subcommittee II plans to propose clarifying the Committee's 
proposals that will be impacted by the ultimate path chosen by the SEC 
regarding international convergence.
     Governance--Subcommittee II plans to propose updating the 
Committee's proposals for recent changes made by the FAF, including 
emphasizing which proposals have yet to be fully addressed. 
Specifically, Subcommittee II is deliberating whether the FAF 
resolutions regarding increased investor representation on the FAF and 
FASB will meet the objective underlying the Committee's developed 
proposal. Subcommittee II would also like to emphasize the importance 
of the FAF establishing clear performance metrics related to the 
efficiency and effectiveness of standards-setting and may propose 
withdrawing the statement that academic representation should not be 
mandated on the FASB.
     Investors--Subcommittee II plans to propose integrating 
the discussion of investor pre-reviews into developed proposal 2.1 and 
propose clarifying that although investor involvement in standards-
setting has been improved recently, more formalized, structured 
involvement utilizing existing advisory groups would be warranted, 
particularly before a document is issued for exposure. In addition, 
Subcommittee II plans to propose clarifying the Committee's view about 
the ``significance'' of investor involvement to further promote 
balanced standards-setting.
     Agenda--Subcommittee II plans to propose clarifying that 
the proposed Agenda Advisory Group was intended to be comprised of key 
decision makers from the SEC, FASB, PCAOB and other constituent groups 
that would meet on a real-time basis to address immediate needs in the 
financial reporting system at large. Such a Financial Reporting Working 
Group would not solely advise the FASB on its agenda. Involvement of 
other constituents could be effectuated by leveraging members or 
executive committees from existing FASB advisory groups. This may 
require the FAF and FASB to reevaluate the composition and 
responsibilities of other FASB advisory groups and agenda

[[Page 29818]]

committees, as well as what input is requested of them and when, to 
improve the efficiency and effectiveness of standards-setting.
     Field Work--Subcommittee II plans to propose clarifying 
that the intent of the proposals on cost-benefit analyses and field 
work were that these processes would benefit from additional 
consistency across major projects and transparency of the process 
followed and conclusions reached.
     Periodic Reviews--Subcommittee II plans to propose 
clarifying that the Committee's proposals regarding periodic reviews of 
new and existing standards were intended to formalize existing 
standards-setting processes for major projects. Subcommittee II may 
also propose dispensing with a bright line time requirement, due to the 
inconsistency of this approach with other Committee proposals and the 
need for the standards-setter and its advisory groups to evaluate the 
facts and circumstances surrounding each major project.

Clarifying SEC Role in Interpreting GAAP

    Subcommittee II understands that the SEC staff is already in the 
process of instituting internal processes that may address many, if not 
all, of the points in the Committee's conceptual approach 2.A regarding 
SEC interpretations of GAAP. Subcommittee II is in the process of 
formulating a developed proposal that considers such improvements, 
which will be presented to the Committee for consideration in July 
2008.

Standards-Setting Priorities

    Conceptual approach 3.C recommends revisiting standards-setting 
priorities. However, Subcommittee II acknowledges that convergence 
matters significantly drive priorities in standards-setting and that 
the convergence paths being considered by the SEC will directly impact 
certain of the Committee's proposals and U.S. standards-setting 
priorities. As such, conceptual approach 2.C may not lead to a proposal 
being presented to the Committee, as this reprioritization is likely 
already being considered by those involved in the international 
convergence dialogue and could be addressed with assistance from the 
proposed Financial Reporting Working Group. However, Subcommittee II is 
deliberating the feasibility of a phase II codification project, 
subject to its path-dependency on international convergence matters, 
within the Committee's discussion of the FASB's current codification 
project and proposed periodic reviews of existing standards. The 
Committee will deliberate this topic in July 2008.

Design of Standards

    Subcommittee II has drafted a preliminary hypothesis related to the 
design of accounting standards based on conceptual approach 2.B from 
the Progress Report for the Committee's consideration, as follows:
    Preliminary Hypothesis: The SEC should encourage the FASB to 
continue to improve the way accounting standards are written by using 
clearly-stated objectives, outcomes and principles that faithfully 
represent the economics of transactions and are responsive to 
investors' needs for clarity, transparency and comparability.
    Design of Standards: As noted in the Progress Report, some 
participants in the U.S. financial reporting community believe that 
certain accounting standards do not clearly articulate the objectives, 
outcomes and principles upon which they are based, because they are 
sometimes obscured by dense language, detailed rules, examples and 
illustrative guidance. This can create uncertainty in the application 
of GAAP. Further, the proliferation of detailed rules fosters 
accounting-motivated structured transactions, as rules cannot cover all 
outcomes. As discussed in chapter 1 of the Progress Report, standards 
that have scope exceptions, safe harbors, cliffs, thresholds and bright 
lines are vulnerable to manipulation by those seeking to avoid 
accounting for the substance of transactions using structured 
transactions that are designed to achieve a particular accounting 
result. This ultimately hurts investors, because it reduces 
comparability and the usefulness of the resulting financial 
information. Therefore, a move toward the use of more objectives, 
outcomes and principles in accounting standards may ultimately improve 
the quality of the financial reporting upon which investors rely.
    The Committee recognized in the Progress Report that the question 
of how to design accounting standards going forward is a critical 
aspect of the standards-setting process and is at the center of a 
decade-long principles-based versus rules-based accounting standards 
debate. There has been much discussion in the marketplace on this topic 
and there are differing views. The SEC has been a frequent participant 
in the debate and has long been supportive of objectives-oriented 
standards.\29\ Rather than engage in such a spurious debate, the 
Committee preferred in the Progress Report to think of the design of 
accounting standards in terms of the characteristics they should 
possess. There are many publications on this topic written by well-
known theorists from the FASB, the IASB, the SEC, accounting firms, 
academia and elsewhere. The most recent example is an omnibus of this 
collective thinking published by the CEOs of the World's Six Largest 
Audit Networks.\30\ Their paper attempts to outline what optimal 
accounting standards should look like in the future and proposes a 
framework the standards-setter should refer to over time to ensure that 
these characteristics are consistently optimized.
---------------------------------------------------------------------------

    \29\ For example, the SEC issued Policy Statement: Reaffirming 
the Status of the FASB as a Designated Private-Sector Standard 
Setter (April 2003), which included numerous recommendations for the 
FAF and FASB to consider, including greater use of principles-based 
accounting standards whenever reasonable to do so. The SEC staff 
also issued Study Pursuant to Section 108(d) of the Sarbanes-Oxley 
Act of 2002 on the Adoption by the United States Financial Reporting 
System of a Principles-Based Accounting System (July 2003), which 
further lauded the benefits of objectives-oriented standards.
    \30\ CEOs of the World's Six Largest Audit Networks, A Proposed 
Framework for Establishing Principles-Based Accounting Standards, 
Global Public Policy Symposium (January 2008).
---------------------------------------------------------------------------

    The FASB has made recent improvements in how it writes accounting 
standards as part of its Understandability initiative and Codification 
project. We support the increased use of clearly-stated objectives, 
outcomes and principles in accounting standards that bring together 
this thinking. We believe the highest goal for accounting standards in 
the future is that they faithfully represent the economics of 
transactions and are responsive to investors' needs for clarity, 
transparency and comparability. Accounting standards that meet these 
criteria, when applied in good faith in a standards-setting system that 
employs the Committee's other proposals, will foster enhanced 
comparability and help to restore trust and confidence in financial 
reporting.
    Although Subcommittee II supports increased use of objectives, 
outcomes and principles, the goal would not be to remove all rules. 
Rather, we agree with the notion that ideal accounting standards lay 
somewhere on the spectrum between principles-based and rules-based and 
that a framework may be helpful to consistently determine where on that 
spectrum new accounting standards should be written over time. This 
would assist the standards-setter in determining rules that might be 
necessary in certain circumstances. For example, if the standards-
setter believes that there is only one way to reflect the

[[Page 29819]]

economics of a transaction while promoting clarity, transparency and 
comparability for investors, it would be reasonable to provide 
prescriptive guidance in addition to objectives or principles.

Exhibit C

SEC Advisory Committee on Improvements to Financial Reporting

Audit Process and Compliance Subcommittee Update

May 2, 2008 Full Committee Meeting

I. Introduction

    The SEC's Advisory Committee on Improvements to Financial Reporting 
(Committee) issued a progress report (Progress Report) on February 14, 
2008.\31\ In chapter 3 of the Progress Report, the Committee discussed 
its work-to-date in the area of audit process and compliance, namely, 
its developed proposals related to providing guidance with respect to 
the materiality and correction of errors; and judgments related to 
accounting matters.
    Since the issuance of the Progress Report, the audit process and 
compliance subcommittee (Subcommittee III) has received a considerable 
amount of public comment regarding the developed proposals included in 
the Progress Report. This public input includes feedback obtained 
during the panel discussions regarding the developed proposals in 
Chapter 3 of the Progress Report held during the Committee's March 13 
open meeting, feedback obtained when certain members of the 
subcommittee met with the PCAOB Standing Advisory Group (SAG) on 
February 27, 2008, feedback obtained when the subcommittee met with 
market participants at our subcommittee meetings and the numerous 
comment letters received by the Committee. Based on this considerable 
public feedback, Subcommittee III believes that there are several areas 
related to the Committee's original developed proposals that warrant 
clarification by the Committee as well as some additional items that 
need to be considered by the Committee. This report represents 
Subcommittee III's latest thinking related to the developed proposals 
in Chapter 3 of the Progress Report and reflects the subcommittee's 
proposed clarifications for the Committee's consideration related to 
the original developed proposals. Subject to further public comment and 
Committee input, Subcommittee III will recommend these revised 
developed proposals to the Committee for its consideration in 
developing the final report, which is expected to be issued in July 
2008.

II. Financial Restatements

    In the Progress Report, the Committee issued three developed 
proposals (developed proposals 3.1, 3.2 and 3.3) related to financial 
restatements. These developed proposals have been the subject of public 
debate and the subject of many comment letters received by the 
Committee. Subcommittee III believes that one cause of the debate 
surrounding these developed proposals relates to a lack of clarity 
regarding the developed proposals.
    First, the developed proposals were not intended to recommend 
elimination of the guidance currently contained in SAB Topic 1M. 
Instead, the developed proposals were intended to enhance the guidance 
in SAB Topic 1M. As stated in the summary of SAB 99, which was codified 
in SAB Topic 1M, ``This staff accounting bulletin expresses the views 
of the staff that exclusive reliance on certain quantitative benchmarks 
to assess materiality in preparing financial statements and performing 
audits of those financial statements is inappropriate; misstatements 
are not immaterial simply because they fall beneath a numerical 
threshold.'' Subcommittee III believes that the guidance in SAB Topic 
1M is appropriate and accomplishes what it was intended to do, which is 
to address situations where errors were not being evaluated for 
materiality simply due to the relatively small size of the error. As 
the SEC staff noted in SAB 99, this concept was not consistent with the 
total mix standard established by the Supreme Court. SAB Topic 1M was 
not written to address all situations one must consider when 
determining if an error is material, yet in practice, SAB Topic 1M is 
often cited as the guidance to use in all materiality decisions. 
Because SAB Topic 1M primarily addresses one issue, which was to 
correct the misperception in practice at the time that small errors 
need not be evaluated for materiality solely based on their size, 
Subcommittee III believes that this has resulted in less consideration 
to the total mix of information in the evaluation of whether an error 
is material or not. Since this is not consistent with the standard 
established by the Supreme Court or as we understand it the intent of 
SAB Topic 1M, Subcommittee III believes that additional guidance is 
needed to supplement the guidance contained in SAB Topic 1M.
    Second, there have been some additional studies of restatements 
that have been published since the issuance of the Progress Report. The 
most significant study is the study commissioned by the U.S. Treasury 
entitled ``The Changing Nature and Consequences of Public Company 
Financial Restatements 1997-2006'', conducted by Professor Susan Scholz 
of the University of Kansas. Subcommittee III believes that the results 
of this study are not inconsistent with the developed proposals in the 
Committee's Progress Report.
---------------------------------------------------------------------------

    \31\ Refer to Progress Report at http://www.sec.gov/rules/other/
2008/33-8896.pdf.
---------------------------------------------------------------------------

    Third, Subcommittee III believes clarifications are needed related 
to the use of the term ``current'' investor in the Progress Report. 
Some have concluded that this term only refers to investors who 
currently own securities of a company. Subcommittee III did not intend 
the Committee's developed proposal to convey such a narrow definition 
of current investor, so there are proposed edits to the developed 
proposal to reflect that the correction of an error should be based on 
the needs of all investors making current investment decisions.
    Fourth, there were several public comments related to the use of 
the term ``sliding scale'' in the developed proposals in the Progress 
Report. Many of these comments were concerned that this term was 
confusing and did not help explain the principles in the developed 
proposal. Subcommittee III does not believe that the use of this term 
is critical to the principles articulated in the developed proposals in 
the Progress Report. Therefore Subcommittee III proposes to remove the 
use of this term in the developed proposals.
    Finally, because Subcommittee III believes that issues related to 
the dark period, most notably the potential high cost to investors 
during the dark period, are very important, a new developed proposal is 
being recommended by the subcommittee to highlight the importance of 
this issue. This new developed proposal contains substantially the same 
wording that was included in the Progress Report, but has been moved to 
give more prominence to this important issue.

III. Judgment

    Similar to the reaction to the Committee's developed proposals 
related to restatements in the Progress Report (Developed Proposals 
3.1, 3.2 and 3.3), there has been much public comment related to the 
Committee's developed proposal 3.4 in the Progress Report related to 
professional judgment. Subcommittee III believes that the comments it 
has received during this

[[Page 29820]]

process have been very helpful to its continuing deliberations on this 
matter. Based on the comments received, Subcommittee III believes that 
some changes are necessary to the developed proposal 3.4 in the 
Progress Report to allow the developed proposal to meet the goals 
established in that Progress Report without the risks that the 
subcommittee has been concerned about from the beginning, such as the 
risk that the developed proposal devolve into a checklist-based 
approach to making judgments and the risk that the proposed framework 
could be used as a shield to protect unreasonable judgments.
    The primary change that Subcommittee III believes should be made is 
to refocus the developed proposal away from a recommendation for a 
framework. While Subcommittee III believes that there is great merit in 
the idea of a framework, the term ``framework'' can imply a mechanistic 
process. Making and evaluating judgments can involve a process, but the 
notion of a process is dangerous because it implies that an outcome can 
be achieved. Indeed, no matter how robust a process one uses to make 
judgments, there can be no guarantee that the outcome will be 
reasonable. Instead, Subcommittee III believes that a preferable way to 
accomplish the goals set forth in the Progress Report would be to have 
the SEC formally articulate in a statement of policy how the SEC 
evaluates judgments, including the factors that it uses as part of its 
evaluation. Therefore, Subcommittee III believes the developed proposal 
should be changed to formally propose such a statement of policy to be 
issued.
    Some commenters have stated that developed proposal 3.4 in the 
Progress Report advocates a safe harbor be established for the exercise 
of professional judgment. Subcommittee III did not intend to advocate 
any particular way for the implementation of developed proposal 3.4. 
Instead, this decision was left to the SEC. With the change in focus 
outlined above, Subcommittee III believes that a statement of policy 
would be the preferred way to implement the revised proposal and 
therefore, there should be no reference to a safe harbor in the revised 
Chapter 3.
    Subcommittee III also proposes to remove the use of the term 
professional when referring to judgment. Subcommittee III believes that 
there could be a misunderstanding that the term ``professional'' 
implies that one must have a professional certification in order to 
make or evaluate a professional judgment. While Subcommittee III 
believes that such professional certifications are important, it did 
not intend to suggest such a requirement for the application or 
evaluation of accounting judgments.

Appendix A

    Subcommittee III has included as Appendix A to this update a 
revised version of Chapter 3 from the Progress Report that reflects the 
proposed edits for the Committee's consideration.

Chapter 3: Audit Process and Compliance

I. Introduction

    We have concentrated our efforts to date regarding audit process 
and compliance on the subjects of financial restatements, including the 
potential benefits from providing guidance with respect to the 
materiality\32\ and correction of errors; and judgments related to 
accounting matters: Specifically, whether guidance on the evaluation of 
judgments would enhance the quality of judgments and the willingness of 
others to respect judgments made.
---------------------------------------------------------------------------

    \32\ A fact is material if there is a substantial likelihood 
that a reasonable investor in making an investment decision would 
consider it as having significantly altered the total mix of 
information available. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 
(1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 
(1976).
---------------------------------------------------------------------------

II. Financial Restatements

II.A. Background

Likely Causes of Restatements
    The number of financial restatements\33\ in the U.S. financial 
markets has been increasing significantly over recent years, reaching 
approximately 1,600 companies in 2006.\34\ Restatements generally occur 
because errors that are determined to be material are found in a 
financial statement previously provided to the public. Therefore, the 
increase in restatements appears to be due to an increase in the 
identification of errors that were determined to be material.
---------------------------------------------------------------------------

    \33\ For the purposes of this chapter, a restatement is the 
process of revising previously issued financial statements to 
reflect the correction of a material error in those financial 
statements. An amendment is the process of filing a document with 
revised financial statements with the SEC to replace a previously 
filed document. A restatement could occur without an amendment, such 
as when prior periods are revised in a current filing with the SEC.
    \34\ U.S. Government Accountability Office (GAO) study, 
Financial Restatements: Update of Public Company Trends, Market 
Impacts, and Regulatory Enforcement Updates (March 2007), and Audit 
Analytics study, 2006 Financial Restatements A Six Year Comparison 
(February 2007).
---------------------------------------------------------------------------

    The increase in restatements has been attributed to various causes. 
These include more rigorous interpretations of accounting and reporting 
standards by preparers, outside auditors, the SEC, and the PCAOB; the 
considerable amount of work done by companies to prepare for and 
improve internal controls in applying the provisions of section 404 of 
the Sarbanes-Oxley Act; and the existence of control weaknesses that 
companies failed to identify or remediate. Some have also asserted that 
the increase in restatements is the result of an overly broad 
application of the concept of materiality and misinterpretations of the 
existing guidance regarding materiality in SAB 99, Materiality (as 
codified in SAB Topic 1M). SAB Topic 1M was written to primarily 
address a specific issue, when seemingly small errors could be material 
due to qualitative factors, however, the guidance in SAB Topic 1M is 
often utilized in all materiality decisions. As a result of this overly 
broad application of SAB Topic 1M, errors may have been deemed to be 
material when an investor\35\ may not consider them to be important.
---------------------------------------------------------------------------

    \35\ We use the term investor to include all people using 
financial statements to make investment decisions.
---------------------------------------------------------------------------

    It is essential that companies, auditors, and regulators strive to 
reduce the frequency and magnitude of errors in financial reporting. 
When material errors occur, however, companies should restate their 
financial statements to correct errors that are important to current 
investors. Investors need accurate and comparable data, and restatement 
is the only means to achieve those goals when previously filed 
financial statements contain material errors. Efforts to improve 
company controls and audit quality in recent years should reduce 
errors, and there is evidence this is currently occurring.\36\ We 
believe that public companies should focus on reducing errors in 
financial statements. At the same time, we believe that some of our 
developed proposals in the areas of substantive complexity, as 
discussed in chapter 1, and the standards-setting process, as discussed 
in chapter 2, will also be helpful in reducing some of the frequency of 
errors in financial statements.
---------------------------------------------------------------------------

    \36\ A Glass Lewis & Co. report, The Tide is Turning (January 
15, 2008), shows that restatements in companies subject to section 
404 of the Sarbanes-Oxley Act have declined for two consecutive 
years.
---------------------------------------------------------------------------

    While reducing errors is the primary goal, it is also important to 
reduce the number of restatements that do not provide important 
information to investors making current investment decisions. 
Restatements can be costly for companies and auditors, may reduce 
confidence in reporting, and may create

[[Page 29821]]

confusion that reduces the efficiency of investor analysis. This 
portion of this chapter describes our proposals regarding: (1) 
Additional guidance on the concept and application regarding 
materiality, and (2) the process for and disclosure of the correction 
of errors.
Our Research
    We have considered several publicly-available studies \37\ on 
restatements. The restatement studies we have reviewed all indicate 
that the total number of restatements has increased in recent years. 
The studies also indicate that there are many different types of errors 
that result in the need for restatements. Market reaction to 
restatements may be one indicator as to whether restatements contain 
information considered by investors to be material. Based on these 
studies, it appears to us that there may be restatements that investors 
may not consider important. We draw this conclusion in part based upon 
the lack of a statistically significant market reaction, particularly 
as it relates to certain types of restatements such as 
reclassifications and restatements affecting non-core expenses.\38\ 
While there are limitations \39\ to using market reaction as a proxy 
for materiality, other trends in these studies are not inconsistent 
with our conclusion--the trend toward restatements involving correction 
of smaller amounts, including amounts in the cash flow statement, and 
the trend toward restatements in cases where there is no evidence of 
fraud or intentional wrongdoing.\40\ Also, while there is recent 
evidence \41\ that the number of restatements has declined in 2007, we 
note that the total number of restatements is still significant. We, 
therefore, believe supplementing existing guidance on determining 
whether an error is material and providing additional guidance on when 
a restatement is necessary for certain types of errors, would be 
beneficial in reducing the frequency of restatements that do not 
provide important information to investors making current investment 
decisions.
---------------------------------------------------------------------------

    \37\ Studies considered include the study commissioned by the 
Department of the Treasury, The Changing Nature and Consequences of 
Public Company Financial Restatements 1997-2006, by Professor Susan 
Scholz, An Analysis of the Underlying Causes of Restatements by 
Professors Marlene Plumlee and Teri Yohn, GAO study, Financial 
Restatements: Update of Public Company Trends, Market Impacts, and 
Regulatory Enforcement Updates (March 2007); Glass Lewis & Co. 
study, The Errors of Their Ways (February 2007); and two Audit 
Analytics studies, 2006 Financial Restatements A Six Year Comparison 
(February 2007) and Financial Restatements and Market Reactions 
(October 2007). We have also considered findings from the PCAOB's 
Office of Research and Analysis's (ORA) working paper, Changes in 
Market Responses to Financial Statement Restatement Announcements in 
the Sarbanes-Oxley Era (October 18, 2007), understanding that ORA's 
findings are still preliminary in nature as the study is still going 
through a peer review process.
    \38\ Professor Scholz's study defines restatements related to 
non-core expenses as ``Any restatement including correction of 
expense (or income) items that arise from accounting for non-
operation or non-recurring activities''. This definition includes 
restatements related to debt and equity instruments, derivatives, 
gain or loss recognition, inter-company investments, contingency and 
commitments, fixed and intangible asset valuation or impairment and 
income taxes.
    \39\ Examples of the limitations in using market reaction as a 
proxy for materiality include (1) The difficultly of measuring 
market reaction because of the length of time between when the 
market becomes aware of a potential restatement and the ultimate 
resolution of the matter, (2) the impact on the market price of 
factors other than the restatement, and (3) the disclosure at the 
time of the restatement of other information, such as an earnings 
release, that may have an offsetting positive market reaction.
    \40\ These trends are addressed in Professor Scholz's study.
    \41\ Glass Lewis & Co. report, The Tide is Turning (January 15, 
2008) indicates that approximately 1 out of every 11 public 
companies had a restatement during 2007.
---------------------------------------------------------------------------

    We have also considered input from equity and credit analysts and 
others about investors' views on materiality and how restatements are 
viewed in the marketplace. Feedback we have received included:
     Bright lines are not really useful in making materiality 
judgments. Both qualitative and quantitative factors should be 
considered in determining if an error is material.
     Companies often provide the market with little financial 
data during the time between a restatement announcement and the final 
resolution of the restatement. Limited information seriously undermines 
the quality of investor analysis, and sometimes triggers potential loan 
default conditions or potential delisting of the company's stock.
     The disclosure provided in connection with restatements is 
not consistently adequate to allow an investor to evaluate the 
likelihood of errors in the future. Notably, disclosures often do not 
provide enough information about the nature and impact of the error, 
and the resulting actions the company is taking.
     Interim periods should be viewed as more than just a 
component of an annual financial statement for purposes of making 
materiality judgments.

II.B. Developed Proposals

    Based on our work to date, we believe that, in addressing a 
financial statement error, it is helpful to consider two sequential 
questions: (1) Was the error in the financial statement material to 
those financial statements when originally filed? and (2) How should a 
material error in previously issued financial statements be corrected? 
We believe that framing the principles necessary to evaluate these 
questions would be helpful. We also believe that in many circumstances 
investors could benefit from improvements in the nature and timeliness 
of disclosure in the period between identifying an error and filing 
restated financial statements.
    With this context, we have developed the following proposals 
regarding the assessment of the materiality of errors to financial 
statements and the correction of financial statements for errors.\42\
---------------------------------------------------------------------------

    \42\ We have developed principles that we believe will be 
helpful in addressing financial statement errors. In developing 
these principles, we have not determined if the principles are 
inconsistent with existing GAAP, such as SFAS No. 154, Accounting 
Changes and Error Corrections, or APB Opinion No. 28, Interim 
Financial Reporting. To the extent that the implementation of our 
proposals would require a change to GAAP, the SEC should work with 
the FASB to revise GAAP.
---------------------------------------------------------------------------

    Developed Proposal 3.1: The FASB or the SEC, as appropriate, should 
supplement existing guidance to reinforce the following concepts:
     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.
    The FASB or the SEC, as appropriate, should also conduct both 
education sessions internally and outreach efforts to financial 
statement preparers and auditors to raise awareness of these issues and 
to promote more consistent application of the concept of materiality.
    The Supreme Court has established that ``a fact is material if 
there is a substantial likelihood that a reasonable investor in making 
an investment decision would consider it as having significantly 
altered the total mix of information available.'' We believe that those 
who judge the materiality of a financial statement error should make 
the decision based upon the interests, and the viewpoint, of a 
reasonable investor and based upon how that error impacts the total mix 
of information available to a reasonable investor. One must ``step into 
the shoes'' of a reasonable investor when making these judgments. We 
believe that too many

[[Page 29822]]

materiality judgments are being made in practice without full 
consideration of how a reasonable investor would evaluate the error. 
When looking at how an error impacts the total mix of information, 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.
    We believe that the current materiality guidance in SAB Topic 1M is 
appropriate in making most materiality judgments. We believe that, in 
current practice, however, this materiality guidance is being 
interpreted generally as being one-directional, that is, as providing 
that qualitative considerations can result in a small error being 
considered material, but that a large error is material without regard 
to qualitative factors. This one-directional interpretation is not 
consistent with the standard established by the Supreme Court, which 
requires an assessment of the total mix of information available to the 
investor making an investment decision. We believe that, in general, 
qualitative factors not only can increase, but also can decrease, the 
importance of an error to the reasonable investor, although we 
acknowledge that there will probably be more times when qualitative 
considerations will result in a small error being considered material 
than they will result in a large error being considered not to be 
material.\43\ Therefore, we recommend that the existing materiality 
guidance be enhanced to clarify that the total mix of information 
available to investors should be the main focus of a materiality 
judgment and that qualitative factors are relevant in analyzing the 
materiality of both large and small errors. We view this recommendation 
as a modest clarification of the existing guidance to conform practice 
to the standard established by the Supreme Court and not a wholesale 
revision to the concepts and principles embedded in existing SEC staff 
guidance in SAB Topic 1M.
---------------------------------------------------------------------------

    \43\ Some have argued that, under such guidance, a very large 
error that affects meaningful financial statement metrics could be 
deemed immaterial by virtue of qualitative factors. The Committee 
believes that when one focuses on the total mix of information, the 
probability of this situation occurring is remote.
---------------------------------------------------------------------------

    The following are examples of some of the qualitative factors that 
could result in a conclusion that a large error is not material. (Note 
that this is not an exhaustive list of factors, nor should this list be 
considered a ``checklist'' whereby the presence of any one of these 
items would make an error not material. Companies and their auditors 
should continue to look at the totality of all factors when making a 
materiality judgment):
     The error impacts metrics that do not drive investor 
conclusions or are not important to investor models.
     The error is a one-time item and does not alter investors' 
perceptions of key trends affecting the company.
     The error does not impact a business segment or other 
portion of the registrant's business that investors regard as driving 
valuation or risks.
    Finally, we recommend that the enhanced guidance suggest some 
factors that are relevant to the analysis of errors in the cash flow 
statement and the balance sheet. We note that the existing guidance 
suggests factors that are relevant primarily to the analysis of the 
materiality of an error in the income statement.
    Internal education and external outreach efforts can be 
instrumental in increasing the awareness of these concepts and ensuring 
more consistent application of materiality. Many of the issues with 
materiality in practice are caused by misunderstandings by preparers, 
auditors and regulators. Elimination of these misunderstandings would 
be a significant step toward reducing restatements that do not provide 
useful information to investors.
    Developed Proposal 3.2: The FASB or the SEC, as appropriate, should 
issue guidance on how to correct an error consistent with the 
principles outlined below:
     All errors, other than clearly insignificant errors, 
should be promptly corrected no later than in the financial statements 
of the period in which the error is discovered. All material errors 
should be disclosed when they are corrected.
     Prior period financial statements should only be restated 
for errors that are material to those prior periods.
     The determination of how to correct a material error 
should be based on the needs of current investors. For example, a 
material error that has no relevance to a current investment decision 
would not require amendment of the annual financial statements in which 
the error occurred, but would need to be promptly corrected and 
disclosed in the current period.
     There may be no need for the filing of amendments to 
previously filed annual or interim reports to reflect restated 
financial statement, if the next annual or interim period report is 
being filed in the near future and that report will contain all of the 
relevant information.
     Restatements of interim periods do not necessarily need to 
result in a restatement of an annual period.
     Corrections of large errors should always be disclosed, 
even if the error was determined not to be material.
    We believe that all errors, excluding clearly insignificant errors, 
should be corrected no later than in the financial statements of the 
annual or interim period in which the error is discovered. The 
correction of errors, even errors that are not material, should not be 
deferred to future periods. Rather, companies should be required to 
correct all errors promptly and make appropriate disclosures about the 
correction, particularly when the errors are material, and should not 
have the option to defer recognition of errors until future financial 
statements. Notwithstanding the foregoing, immaterial errors discovered 
shortly before the issuance of the financial statements may not need to 
be corrected until the next annual or interim period being reported 
upon when earlier correction is impracticable.\44\
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    \44\ We understand that sometimes there may be immaterial 
differences between a preparer's estimate of an amount and the 
independent auditor's estimate of an amount that exist when 
financial statements are issued. These differences might or might 
not be errors, and may require additional work to determine the 
nature and actual amount of the error. This additional work is not 
necessary for the preparer or the auditor to agree to release the 
financial statements. Due care should be taken in developing any 
guidance in this area to provide an exception for these legitimate 
differences of opinion, and to ensure that any requirement to 
correct all ``errors'' would not result in unnecessary work for 
preparers or auditors.
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    The current guidance that is detailed in SAB 108 (as codified in 
SAB Topic 1N) may result in the restatement of prior annual periods for 
immaterial errors occurring in those periods because the cumulative 
effect of these prior period errors would be material to the current 
annual period, if the prior period errors were corrected in the current 
annual period. By correcting small errors when they are identified, a 
company will eliminate the possibility that the continuation of the 
error over a period of time will result in the total amount of the 
error becoming material to a company's financial statements and 
requiring correction at that time. Newly discovered errors that had 
occurred over a period of time when they were not material, however, 
would still trigger the need for correction. In the process of 
reflecting these immaterial corrections to prior annual periods, some 
believe that the prior annual period financial statements should 
indicate that they have been restated.

[[Page 29823]]

There is diversity in practice on this issue, and clarification is 
needed from the SEC on the intent of SAB Topic 1N. We believe that 
prior annual period financial statements should not be restated for 
errors that are immaterial to the prior annual period. Instead of the 
approach specified in Topic 1N, we believe that, where errors are not 
material to the prior annual periods in which they occurred but would 
be material if corrected in the current annual period, the error could 
be corrected in the current annual period \45\ with appropriate 
disclosure at the time the current annual period financial statements 
are filed with the SEC.
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    \45\ We are focused on the principle that prior periods should 
not be restated for errors that are not material to those periods. 
Correction in the current period of errors that are not material to 
prior periods could be accomplished through an adjustment to equity 
or to current period income (which might potentially require an 
amendment to GAAP). We believe that there are merits in both 
approaches and that the FASB and the SEC, as appropriate, should 
carefully weigh both approaches before determining the actual 
approach to utilize.
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    We believe that the determination of how errors should be corrected 
should be based on the needs of investors making current investment 
decisions. This determination should take into account the facts and 
circumstances of each error. For example, a prior period error that was 
material to that prior period but that does not affect the annual 
financial statements or financial information included within a 
company's most recent filing with the SEC may not need to be corrected 
through an amendment to prior period filings if the financial 
statements that contain the error are determined to be irrelevant to 
investors making current investment decisions. Such errors would be 
corrected in the period in which they are discovered with appropriate 
disclosure about the error and the periods impacted. This approach 
provides investors making current investment decisions with more timely 
financial reports and avoids the costs to investors of delaying prompt 
disclosure of current financial information in order for a company to 
correct multiple prior filings.
    For material errors that are discovered within a very short time 
period prior to a company's next regularly scheduled reporting date, it 
may be appropriate in certain instances to report the restatement in 
the next filing with appropriate disclosure of the error and its impact 
on prior periods, instead of amending previous filings with the SEC. 
This option should be further studied with regard to the possibility of 
abuse and, if appropriate, should be included in the overall guidance 
on how to correct errors.
    Assuming that there is an error in an interim period within an 
annual period for which financial statements have previously been filed 
with the SEC, the following guidance should be utilized:
     If the error is not material to either the previously 
issued interim period or to the previously issued annual period, the 
previously issued financial statements should not be restated.
     If the prior period error is determined to be material 
only to the previously issued interim period, but not the previously 
issued annual period, then only the previously issued interim period 
should be restated (i.e., the annual period that is already filed 
should not be restated and the Form 10-K should not be amended). 
However, there should be appropriate disclosure in the company's next 
Form 10-K to explain the discrepancy in the results for the interim 
periods during the previous annual period on an aggregate basis and the 
reported results for that annual period.
    We believe that investors should be informed about all large errors 
when they are corrected. Even if a large error is determined to be not 
material because of qualitative factors, there should be appropriate 
disclosure about the error in the period in which the error is 
corrected.
    We believe that the issuance by the FASB or the SEC, as 
appropriate, of guidance on how to correct and disclose errors in 
previously issued financial statements will provide to investors higher 
quality and more timely information (e.g., less delay occasioned by the 
need for restatement of prior period financial statements for errors 
that are not material and for errors that have no relevance to 
investors making current investment decisions) and reduce the burdens 
on companies related to the preparation of amended reports. Since our 
proposal would require prompt correction and full disclosure about all 
material errors, all large errors that are considered to be not 
material as well as many other types of errors, it would enhance 
transparency of accounting errors and help to eliminate the phenomenon 
of so-called ``stealth restatements''--when an error impacts past 
financial statements without disclosure of such error in current 
financial filings.
    Developed Proposal 3.3: The FASB or the SEC, as appropriate, should 
issue guidance on disclosure during the period in which the restatement 
is being prepared, about the need for a restatement and about the 
restatement itself, to improve the adequacy of this disclosure based on 
the needs of investors:
    Typically, the restatement process involves three primary reporting 
stages:
    1. The initial notification to the SEC and investors that there is 
a material error and that the financial statements previously filed 
with the SEC can no longer be relied upon;
    2. The ``dark period'' or the period between the initial 
notification to the SEC and the time restated financial statements are 
filed with the SEC; and
    3. The filing of restated financial statements with the SEC.
    We believe that a major effect on investors due to restatements is 
the lack of information when companies are silent during stage 2, or 
the ``dark period.'' This silence creates significant uncertainty 
regarding the size and nature of the effects on the company of the 
issues leading to the restatement. This uncertainty often results in 
decreases in the company's stock price. In addition, delays in filing 
restated financial statements may create default conditions in loan 
covenants; these delays may adversely affect the company's liquidity. 
We understand that, in the current legal environment, companies are 
often unwilling to provide disclosure of uncertain information. 
However, we believe that when companies are going through the 
restatement process, they should be encouraged to continue to provide 
any reasonably reliable financial information that they can, 
accompanied by appropriate explanations of ways in which the 
information could be affected by the restatement. Consequently, 
regulators should evaluate the company's disclosures during the ``dark 
period,'' taking into account the difficulties of generating reasonably 
reliable information before a restatement is completed.
    We believe that 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. Specifically, we believe that all companies that have a 
restatement should be required to disclose information related to: (1) 
The nature of the error, (2) the impact of the error, and (3) 
management's response to the error, to the extent known, during all 
three stages of the restatement process. Some suggestions of 
disclosures that would be made by companies include the following:
    Nature of error:
     Description of the error;
     Periods affected and under review;

[[Page 29824]]

     Material items in each of the financial statements subject 
to the error and pending restatement;
     For each financial statement line item, the amount of the 
error or range of potential error;
     Identity of business units/locations/segments/subsidiaries 
affected.
    Impact of error:
     Updated analysis on trends affecting the business if the 
error impacted key trends;
     Loan covenant violations, ability to pay dividends, and 
other effects on liquidity or access to capital resources;
     Other areas, such as loss of material customers or 
suppliers.
Management Response
     Nature of the control weakness that led to the restatement 
and corrective actions, if any, taken by the company to prevent the 
error from occurring in the future;
     Actions taken in response to covenant violations, loss of 
access to capital markets, loss of customers, and other consequences of 
the restatement.
    If there are material developments related to the restatement, 
companies should update this disclosure on a periodic basis during the 
restatement process, particularly when quarterly or annual reports are 
required to be filed, and provide full and complete disclosure within 
the filing with the SEC that includes the restated financial 
statements.
    Developed Proposal 3.4: The FASB or the SEC, as appropriate, should 
develop and issue guidance on applying materiality to errors identified 
in prior interim periods and how to correct these errors. This guidance 
should reflect the following principles:
     Materiality in interim period financial statements must be 
assessed based on the perspective of the reasonable investor.
     When there is a material error in an interim period, the 
guidance on how to correct that error should be consistent with the 
principles outlined in developed proposal 3.2.
    Based on prior restatement studies, approximately one-third of all 
restatements involved only interim periods. Authoritative accounting 
guidance on assessing materiality with respect to interim periods is 
currently limited to paragraph 29 of APB Opinion No. 28, Interim 
Financial Reporting.\46\ Differences in interpretation of this 
paragraph have resulted in variations in practice that have increased 
the complexity of financial reporting. This increased complexity 
impacts preparers and auditors, who struggle with determining how to 
evaluate the materiality of an error to an interim period, and also 
impacts investors, who can be confused by the inconsistency between how 
companies evaluate and report errors. We believe that guidance as to 
how to evaluate errors related to interim periods would be beneficial 
to preparers, auditors and investors.
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    \46\ Paragraph 29 of APB Opinion No. 28, Interim Financial 
Reporting, states the following:
    In determining materiality for the purpose of reporting the 
cumulative effect of an accounting change or correction of an error, 
amounts should be related to the estimated income for the full 
fiscal year and also to the effect on the trend of earnings. Changes 
that are material with respect to an interim period but not material 
with respect to the estimated income for the full fiscal year or to 
the trend of earnings should be separately disclosed in the interim 
period.
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    We have observed that a large part of the dialogue about interim 
materiality has focused on whether an interim period should be viewed 
as a discrete period or an integral part of an annual period. 
Consistent with the view expressed at the outset of this section, we 
believe that the interim materiality dialogue could be greatly 
simplified if that dialogue were refocused to address two sequential 
questions: (1) What principles should be considered in determining the 
materiality of an error in interim period financial statements? and (2) 
How should errors in previously issued interim financial statements be 
corrected? We believe that additional guidance on these questions, 
which are extensions of the basic principles outlined in developed 
proposals 3.1 and 3.2 above, would provide useful guidance in assessing 
and correcting interim period errors. We believe that while these 
principles would assist in developing guidance related to interim 
periods, additional work should also be performed to fully develop 
robust guidance regarding errors identified in interim periods.
    We believe that the determination of whether an interim period 
error is material should be made based on the perspective of a 
reasonable investor, not whether an interim period is a discrete 
period, an integral part of an annual period, or some combination of 
both. An interim period is part of a larger mix of information 
available to a reasonable investor. As one example, a reasonable 
investor would use interim financial statements to assess the 
sustainability of a company's operations and cash flows. In this 
example, if an error in interim financial statements did not impact the 
sustainability of a company's operations and cash flows, the interim 
period error may very well not be material given the total mix of 
information available. Similarly, just as a large error in annual 
financial statements does not determine by itself whether an error is 
material, the size of an error in interim financial statements should 
also not be necessarily determinative as to whether an error in interim 
financial statements is material.
    We believe that applying the principles set forth above would 
reduce restatements by providing a company the ability to correct in 
the current period immaterial errors in previously issued financial 
statements and as a practical matter obviate the need to debate whether 
the interim period is a discrete period, an integral part of an annual 
period, or some combination of both.
    We also note that these principles will provide a mechanism, other 
than restatement, to correct through the current period a particular 
error that has often been at the center of the interim materiality 
debate--a newly discovered error that has accumulated over one or more 
annual or interim periods, but was not material to any of those prior 
periods.

III. Judgment

III.A. Background

Overview
    Judgment is not new to the areas of accounting, auditing, or 
securities regulation--the criteria for making and evaluating judgment 
have been a topic of discussion for many years. The recent increased 
focus on judgment, however, comes from several different developments, 
including changes in the regulation of auditors and a focus on more 
``principles-based'' standards--for example, FASB standards on fair 
value and IASB standards. Investors will benefit from more emphasis on 
``principles-based'' standards, since ``rules-based'' standards (as 
discussed in chapters 1 and 2) may provide a method, such as through 
exceptions and bright-line tests, to avoid the accounting objectives 
underlying the standards. If properly implemented, ``principles-based'' 
standards should improve the information provided to investors while 
reducing the investor's concern about ``financial engineering'' by 
companies using the ``rules'' to avoid accounting for the substance of 
a transaction. While preparers appear supportive of a move to less 
prescriptive guidance, they have expressed concern regarding the 
perception that current practice by regulators in evaluating judgments 
does not provide an environment in which such judgments may be 
generally respected. This, in turn, can lead to repeated calls for more 
rules, so that the

[[Page 29825]]

standards can be comfortably implemented.
    Many regulators also appear to encourage a system in which 
preparers can use their judgment to determine the most appropriate 
accounting and disclosure for a particular transaction. Regulators 
assert that they do respect judgments, but may also express concerns 
that some companies may attempt to inappropriately defend certain 
errors as ``reasonable judgments.'' Identifying standard processes for 
making judgments and criteria for evaluating those judgments, after the 
fact, may provide an environment that promotes the use of judgment and 
encourages consistent evaluation practices among regulators.
Goals of Potential Guidance on Judgments
    The following are several issues that any potential guidance 
related to judgments may help address:
    a. Investors' lack of confidence in the use of judgment--Guidance 
on judgments may provide investors with greater comfort that there is 
an acceptable rigor that companies follow in exercising reasonable 
judgment.
    b. Preparers' concern regarding whether reasonable judgments are 
respected--In the current environment, preparers may be afraid to 
exercise judgment for fear of having their judgments overruled, after 
the fact by regulators.
    c. Lack of agreement in principle on the criteria for evaluating 
judgments--The criteria for evaluating reasonable judgments, including 
the appropriate role of hindsight in the evaluation, may not be clearly 
defined and thus may lead to increased uncertainty.
    d. Concern over increased use of ``principles-based'' standards--
Companies may be less comfortable with their ability to implement more 
``principles-based'' standards if they are concerned about how 
reasonable judgments are reached and how they will be assessed.
Categories of Judgments That Are Made in Preparing Financial Statements
    There are many categories of accounting and auditing judgments that 
are made in preparing financial statements, and any guidance should 
encompass all of these categories, if practicable. Some of the 
categories of accounting judgment are as follows:
    1. Selection of accounting standard.
    In many cases, the selection of the appropriate accounting standard 
under GAAP is not a highly complex judgment (e.g., leases would be 
accounted for using lease accounting standards and pensions would be 
accounted for using pension accounting standards). However, there are 
cases in which the selection of the appropriate accounting standard can 
be highly complex.
    For example, the standards on accounting for derivatives contain a 
definition of a derivative and provide scope exceptions that limit the 
applicability of the standard to certain types of derivatives. To 
evaluate how to account for a contract that has at least some 
characteristics of a derivative, one would first have to determine if 
the contract met the definition of a derivative in the accounting 
standard and then determine if the contract would meet any of the scope 
exceptions that limited the applicability of the standard. Depending on 
the nature and terms of the contract, this could be a complex judgment 
to make, and one on which experienced accounting professionals can have 
legitimate differing, yet acceptable, opinions.
    2. Implementation of an accounting standard.
    After the correct accounting standard is identified, there are 
judgments to be made during its implementation.
    Examples of implementation judgments include determining if a hedge 
is effective, if a lease is an operating or a capital lease, and what 
inputs and methodology should be utilized in a fair value calculation. 
Implementation judgments can be assisted by implementation guidance 
issued by standards-setters, regulators, and other bodies; however, 
this guidance could increase the complexity of selecting the correct 
accounting standard, as demonstrated by the guidance issued on 
accounting for derivatives.
    Further, many accounting standards use wording such as 
``substantially all'' or ``generally.'' The use of such qualifying 
language can increase the amount of judgment required to implement an 
accounting standard. In addition, some standards may have potentially 
conflicting statements.
    3. Lack of applicable accounting standards.
    There are some transactions that may not readily fit into a 
particular accounting standard. Dealing with these ``gray'' areas of 
GAAP is typically highly complex and requires a great deal of judgment 
and accounting expertise. In particular, many of these judgments use 
analogies from existing standards that require a careful consideration 
of the facts and circumstances involved in the judgment.
    4. Financial Statement Presentation.
    The appropriate method to present, classify and disclose the 
accounting for a transaction in a financial statement can be highly 
subjective and can require a great deal of judgment.
    5. Estimating the actual amount to record.
    Even when there is little debate as to which accounting standard to 
apply to a transaction, there can be significant judgments that need to 
be made in estimating the actual amount to record.
    For example, opinions on the appropriate standard to account for 
loan losses or to measure impairments of assets typically do not 
differ. However, the assumptions and methodology used by management to 
actually determine the allowance for loan losses or to determine an 
impairment of an asset can be a highly judgmental area.
    6. Evaluating the sufficiency of evidence.
    Not only must one make a judgment about how to account for a 
transaction, the sufficiency of the evidence used to support the 
conclusion must be evaluated. In practice, this is typically one of the 
most subjective and difficult judgments to make.
    Examples include determining if there is sufficient evidence to 
estimate sales returns or to support the collectability of a loan.
Levels of Judgment
    There are many levels of judgment that occur related to accounting 
matters. Preparers must make initial judgments about uncertain 
accounting issues; the preparer's judgment may then be evaluated or 
challenged by auditors, investors, regulators, legal claimants, and 
even others, such as the media. Therefore, in developing potential 
guidance, differences in role and perspective between those who make a 
judgment and those who evaluate a judgment should be carefully 
considered. Guidance should not make those who evaluate a judgment re-
perform the judgment according to the guidance. Instead, guidance 
should provide clarity to those who would make a judgment on factors 
that those who would evaluate the judgment would consider while making 
that evaluation.
Hindsight
    The use of hindsight to evaluate a judgment where the relevant 
facts were not available at the time of the initial release of the 
financial statements (including interim financial statements) is not 
appropriate. Determining at what point the relevant facts were known to 
management, or should have been

[[Page 29826]]

known,\47\ can be difficult, particularly for regulators who are often 
evaluating these circumstances after substantial time has passed. 
Therefore, the use of hindsight should only be used based on the facts 
reasonably available at the time the annual or interim financial 
statements were issued.
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    \47\ We believe that those making a judgment should be expected 
to exercise due care in gathering all of the relevant facts prior to 
making the judgment.
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Form of Potential Guidance
    We believe that there are many different ways that potential 
guidance on judgment could be provided. To be successful, however, we 
believe that guidance on judgment should not eliminate debate, nor be 
inflexible or mechanical in application. Rather, the guidance should 
encourage preparers to organize their analysis and focus preparers and 
others on areas to be addressed; thereby improving the quality of the 
judgment and likelihood that regulators will accept the judgment. Any 
guidance issued should be designed to stimulate a rigorous, thoughtful 
and deliberate process rather than a checklist-based approach for 
making and evaluating judgments.
    One potential way to accomplish the goals we set forth earlier as 
well as to guard against the potential that such guidance would develop 
into a checklist-based approach is for the SEC to formally state its 
approach to evaluating judgments. As discussed earlier in this report, 
one of the major concerns surrounding the use of judgment is the 
possibility of a regulator ``second guessing'' the reasonableness of a 
judgment after the fact. We believe that a primary cause of this 
concern is a lack of clarity and transparency into the process the SEC 
uses to evaluate the reasonableness of judgments. The SEC has 
articulated its policies in the past with success. Examples of previous 
articulations of policy by the SEC include the ``Seaboard'' report 
(October 23, 2001) relating to the impact of a company's cooperation on 
a potential SEC enforcement case and the SEC's framework for assessing 
the appropriateness of corporate penalties (January 4, 2006). We 
believe that a statement of policy could implement the goals we have 
articulated and therefore recommend that the SEC and the PCAOB issue 
statements of policy describing how they evaluate the reasonableness of 
accounting and auditing judgments.
The Nature and Limitations of GAAP
    Some have suggested that potential judgment guidance for the 
selection and implementation of GAAP be a requirement to reflect the 
economic substance of a transaction or be a standard of selecting the 
``high road'' in accounting for a transaction. We agree that 
qualitative standards for GAAP such as these would be desirable and we 
encourage regulators and standards-setters to move financial reporting 
in this direction. However, such standards are not always present in 
financial reporting today and we cannot recommend the articulation of 
such standards in an SEC statement of policy without anticipating a 
fundamental long-term revision of GAAP--a change that would be beyond 
our purview and one that would not be doable in the near- or 
intermediate-term.
    For example, there is general agreement that accounting should 
follow the substance and not just the form of a transaction or event. 
Many believe that this fundamental principle should be extended to 
require that all GAAP judgments should reflect economic substance. 
However, reasonable people disagree on what economic substance actually 
is, and many would conclude that significant parts of current GAAP do 
not require and do not purport to measure economic substance (e.g., 
accounting for leases, pensions, certain financial instruments and 
internally developed intangible assets are often cited as examples of 
items reported in accordance with GAAP that would not meet many 
reasonable definitions of economic substance).
    Similarly, some would like financial reporting to be based on the 
``high road''--a requirement to use the most preferable principle in 
all instances. Unfortunately, today a preparer is free to select from a 
variety of acceptable methods allowed by GAAP (e.g., costing inventory, 
measuring depreciation, and electing to apply hedge accounting are just 
some of the many varied methods allowed by GAAP) without any 
qualitative standard required in the selection process. In fact, a 
preferable method is required to be followed only when a change in 
accounting principle is made, and a less preferable alternative is 
fully acceptable absent such a change.
    We believe that adopting a requirement that accounting judgments 
reflect economic substance or the ``high road'' would require a 
revolutionary change not achievable in the foreseeable future. Our 
suggestion that the SEC issue a statement of policy relating to its 
evaluation of judgments could and we believe would enhance adherence to 
GAAP, but it cannot be expected to correct inherent weaknesses in the 
standards to which it would be applied.

III.B. Developed Proposals

    We have developed the following proposal:
    Developed Proposal 3.5: The SEC should issue a statement of policy 
articulating how it evaluates the reasonableness of accounting 
judgments and include factors that it considers when making this 
evaluation. The PCAOB should also adopt a similar approach with respect 
to auditing judgments.
    The statement of policy applicable to accounting-related judgments 
should address the choice and application of accounting principles, as 
well as estimates and evidence related to the application of an 
accounting principle. We believe that a statement of policy that is 
consistent with the principles outlined in this developed proposal to 
cover judgments made by auditors based on the application of PCAOB 
auditing standards would be very beneficial to auditors. Therefore, we 
propose that the PCAOB develop and articulate guidance related to how 
the PCAOB, including its inspections and enforcement divisions, would 
evaluate the reasonableness of judgments made based on PCAOB auditing 
standards. The PCAOB statement of policy should acknowledge that the 
PCAOB 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.
    We believe that it would be useful if the SEC also set forth in the 
statement of policy factors that it looks to when evaluating the 
reasonableness of preparers' accounting judgments.
The Concept of Judgment in Accounting Matters
    Judgment, with respect to accounting matters, should be exercised 
by a person or persons who have the appropriate level of knowledge, 
experience, and objectivity and form an opinion based on the relevant 
facts and circumstances within the context provided by applicable 
accounting standards. Judgments could differ between knowledgeable, 
experienced, and objective persons. Such differences between reasonable 
judgments do not, in themselves, suggest that one judgment is wrong and 
the other is correct. Therefore, those who evaluate judgments should 
evaluate the reasonableness of the judgment, and should not base their 
evaluation on whether the judgment is different from the opinion that 
would have been reached by the evaluator.

[[Page 29827]]

    We have listed below various factors that we believe preparers 
should consider when making accounting judgments. The SEC may want to 
take these factors into account in developing its statement of policy. 
We also believe that a suggestion by the SEC that preparers should 
carefully consider these factors when making accounting judgments would 
be beneficial in not only increasing the quality of judgments, but also 
in making sure that the SEC and preparers will be able to more 
efficiently resolve potential differences during the SEC's review of 
preparer's filings. The mere consideration by a preparer of these 
factors in a SEC statement of policy would not prevent a regulator from 
asking appropriate questions about the accounting judgments made by the 
preparer or asking companies to correct unreasonable judgments, 
however. In fact, there is no guarantee that the preparer's 
consideration of the SEC's suggested factors articulated in a statement 
of policy would result in a reasonable judgment being reached. Rather, 
the statement of policy should be designed to encourage preparers to 
organize their analysis and focus preparers and others on areas that 
would be the focus of the SEC's review, thereby improving the quality 
of the judgment and likelihood that regulators will accept the 
judgment. We encourage the SEC to seek to accept a range of alternative 
reasonable judgments when preparers make good faith attempts to reach a 
reasonable judgment. A preparer's failure to follow the SEC's suggested 
factors in its statement of policy, however, would not imply that the 
judgment is unreasonable.
    We would expect that, in the evaluation of judgments made using the 
factors that are cited below, the focus would be on significant matters 
requiring judgment that could have a material effect on the financial 
statements taken as a whole. We recognize that the facts and 
circumstances of each judgment may indicate that certain factors are 
more important than others. These factors would have a greater 
influence in an evaluation of the reasonableness of a judgment made by 
a preparer.
Factors to Consider When Evaluating the Reasonableness of a Judgment
    While we believe that the SEC should articulate the factors that it 
uses when evaluating the reasonableness of a judgment, we believe that 
the statement of policy would be even more useful to preparers if the 
SEC also made suggestions for ways in which accounting judgments could 
be made.
    We believe that accounting judgments should be based on a critical 
and reasoned evaluation made in good faith and in a rigorous, 
thoughtful and deliberate manner. We believe that preparers should have 
appropriate controls in place to ensure adequate consideration of all 
relevant factors. Factors applicable to the making of an accounting 
judgment include the following:
    1. The preparer's analysis of the transaction, including the 
substance and business purpose of the transaction;
    2. The material facts reasonably available at the time that the 
financial statements are issued;
    3. The preparer's review and analysis of relevant literature, 
including the relevant underlying principles;
    4. The preparer's analysis of alternative views or estimates, 
including pros and cons for reasonable alternatives;
    5. The preparer's rationale for the choice selected, including 
reasons for the alternative or estimate selected and linkage of the 
rationale to investors' information needs and the judgments of 
competent external parties;
    6. Linkage of the alternative or estimate selected to the substance 
and business purpose of the transaction or issue being evaluated;
    7. The level of input from people with an appropriate level of 
professional expertise; \48\
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    \48\ In many cases, input from professional experts would 
include consultation with a preparer's independent auditors or other 
competent external parties, such as valuation specialists, actuaries 
or counsel.
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    8. The preparer's consideration of known diversity in practice 
regarding the alternatives or estimates; \49\
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    \49\ If there is not diversity in practice, it would be 
significantly harder to select a different alternative.
---------------------------------------------------------------------------

    9. The preparer's consistency of application of alternatives or 
estimates to similar transactions;
    10. The appropriateness and reliability of the assumptions and data 
used;
    11. The adequacy of the amount of time and effort spent to consider 
the judgment.
    When considering these factors, it would be expected that the 
amount of documentation, disclosure, input from professional experts, 
and level of effort in making a judgment would vary based on the 
complexity, nature (routine versus non-routine) and materiality of a 
transaction or issue requiring judgment.
    Material issues or transactions should be disclosed appropriately. 
We note that existing disclosure requirements should be sufficient to 
generate \50\ transparent disclosure that enables an investor to 
understand the transaction and assumptions that were critical to the 
judgment. The SEC has provided in the past, and should continue to 
consider providing, additional guidance on existing disclosure 
requirements to encourage more transparent disclosure. In addition, 
when evaluating the reasonableness of a judgment, regulators should 
take into account the disclosure relevant to the judgment.
---------------------------------------------------------------------------

    \50\ Existing disclosure requirements would include the guidance 
on critical accounting estimates in the Commissions Release No. 33-
8350 ``Commission Guidance Regarding Management's Discussion and 
Analysis of Financial Condition and Results of Operations, the 
Commissions Release No. 33-8040 ``Cautionary Advice Regarding 
Disclosure About Critical Accounting Policies'' and Accounting 
Principles Board Opinion No. 22 ``Disclosure of Accounting 
Policies''. We also encourage the SEC to continue to remind 
preparers of ways to improve the transparency of disclosure, such as 
through statements like the Sample Letter sent to Public Companies 
on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value 
Measurements) issued by the Division of Corporation Finance in March 
2008.
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    Documentation--The alternatives considered and the conclusions 
reached should be documented contemporaneously. The lack of 
contemporaneous documentation may not mean that a judgment was 
incorrect, but would complicate an explanation of the nature and 
propriety of a judgment made at the time of the release of the 
financial statements.

Exhibit D

SEC Advisory Committee on Improvements to Financial Reporting

Delivering Financial Information Subcommittee Update

May 2, 2008 Full Committee Meeting

I. Introduction

    The SEC's Advisory Committee on Improvements to Financial Reporting 
(Committee) issued a progress report (Progress Report) on February 14, 
2008.\51\ In chapter 4 of the Progress Report, the Committee discussed 
its work-to-date in the area of delivering financial information 
including its developed proposals relating to XBRL tagging of financial 
information and improved use of corporate Web sites and its future 
considerations relating to disclosure of key performance indicators, 
improved quarterly press release disclosures and timing, and the 
inclusion of executive summaries in public company periodic reports.
---------------------------------------------------------------------------

    \51\ Refer to Progress Report at http://www.sec.gov/rules/other/
2008/33-8896.pdf.
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    Since the issuance of the Progress Report, the delivering financial 
information subcommittee (Subcommittee IV) has deliberated further the 
areas of improved use of

[[Page 29828]]

corporate Web sites, disclosure of key performance indicators, improved 
quarterly press release disclosures and timing and inclusion of 
executive summaries. This report represents Subcommittee IV's latest 
thinking, including its consideration of input received through comment 
letters and received orally at the March 14, 2008 Committee meeting in 
San Francisco and subsequent Subcommittee meeting with industry 
participants. Subject to further public comment, Subcommittee IV will 
recommend the following preliminary hypotheses to the full Committee 
for its consideration in developing the final report, which it expects 
to issue in July 2008.

II. XBRL

    In the Progress Report, the Committee issued a developed proposal 
regarding XBRL (developed proposal 4.1). Refer to the Progress Report 
for additional discussion of this developed proposal. At the Committee 
meeting on March 14, 2008 held in San Francisco, the Committee received 
oral and written input from market participants regarding the XBRL 
developed proposal. The Subcommittee understands the SEC has scheduled 
an open meeting on May 14, 2008 to consider whether to propose 
amendments to provide for corporate financial statement information to 
be filed with the SEC in interactive data format, and a near- and long-
term schedule therefore. Subcommittee IV proposes no revisions at this 
time to the developed proposal.

III. Use of Corporate Web Sites

    In the Progress Report, the Committee issued a developed proposal 
regarding the use of corporate Web sites and the development of uniform 
best practices regarding corporate Web site use by industry 
participants (developed proposal 4.2). Refer to the Progress Report for 
additional discussion of this developed proposal. The Committee heard 
additional input from industry participants, including newswire 
services, reporting companies, investors, and securities lawyers 
regarding the developed proposal as part of the comments received on 
the Progress Report. The Subcommittee heard from companies and 
investors about the value of corporate Web site disclosures as an 
additional, though not exclusive, means of providing information to the 
market in a timely manner available to all persons. Subcommittee IV 
proposes no significant revisions at this time to the developed 
proposals regarding corporate Web sites and industry developed best 
practice guidelines.

IV. Disclosures of KPIs and Other Metrics To Enhance Business Reporting

Preliminary Hypothesis 1

    The SEC should encourage private sector initiatives targeted at 
best practice development of company use of Key Performance Indicators 
(KPIs) in their business reports. The SEC should encourage private 
sector dialogue, involving preparers, investors, and other interested 
industry participants, such as consortia that have long supported KPI-
like concepts, to generate understandable, consistent, relevant and 
comparable KPIs on an industry-specific and relevant activity basis. 
The SEC also should encourage companies to provide, explain, and 
consistently disclose period-to-period company-specific KPIs. The SEC 
should consider reiterating and expanding its interpretive guidance 
regarding disclosures of KPIs in MD&A and other company disclosures.
    The Committee should further acknowledge the useful work of those 
consortia that endeavor to go beyond the limited scope of the 
Committee's recommendation to provide an overall structure which 
provides a linking of financial and KPI indicators into a seamless 
whole.
Background
    As the Committee noted in the Progress Report, enhanced business 
reporting and key performance indicators (KPIs) are disclosures about 
the aspects of a company's business that provide significant insight 
into the sources of its value. The Enhanced Business Reporting 
Consortium,\52\ has stated that the value drivers for a business ``can 
be measured numerically through KPIs or may be qualitative factors such 
as business opportunities, risks, strategies and plans--all of which 
permit assessment of the quality, sustainability and variability of its 
cash flows and earnings.'' KPIs include supplemental non-GAAP financial 
reporting disclosures that proponents have stated can improve 
disclosures by public companies. Such KPIs also may include non-
financial measures. KPIs are leading indicators of financial results 
and intangible assets that are not necessarily encompassed on a 
company's balance sheet and can provide more transparency and 
understanding about the company to investors. Proponents of the use of 
KPIs note that they are important because they inform judgments about a 
company's future cash flows--and form the basis for a company's stock 
price. Managers and boards of directors of companies use KPIs to 
monitor performance of companies and of management. Market participants 
and the SEC have identified KPIs as important supplements to GAAP-
defined financial measures.
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    \52\ The Enhanced Business Reporting Consortium was founded by 
the AICPA, Grant Thornton LLP, Microsoft Corporation, and 
PricewaterhouseCoopers in 2005 upon the recommendation of the AICPA 
Special Committee on Enhanced Business Reporting. The EBRC is an 
independent, market-driven non-profit collaboration focused on 
improving the quality, integrity and transparency of information 
used for decision-making in a cost-effective, time efficient manner.
---------------------------------------------------------------------------

    The Committee understands that investment professionals concur that 
investors are very interested in non-financial information as a way to 
better understand the businesses they invest in. They recognize that 
financial reports provide an accounting of past events and a current 
view of the financial condition of the company. The financials are 
viewed as an end-of-process result delivered as a combination of market 
conditions and company business strategies, processes and execution. 
The financials are, by their nature, not necessarily forward-looking 
indicators. Of interest to many investors from a business reporting 
standpoint is information regarding the fundamental drivers of the 
business and metrics used to give evidence as to how the business is 
being managed in the environment it finds itself in. Financial 
reporting captures some aspects of this but not all and, in fact, 
financial statements are not currently designed to provide a broader 
picture of the company and its operations.
    From a corporate preparer standpoint, management uses KPIs as key 
metrics with which to direct the company as part of the strategic 
planning process both in terms of goal setting and as a way to provide 
analysis and feedback. In that regard the degree to which companies are 
comfortable sharing these metrics with shareholders, communication 
would be greatly enhanced. By its very nature such communication would 
increase the fundamental transparency of the business. Numerous prior 
studies have shown that greater transparency on the part of 
corporations reduces the company's cost of capital and no doubt 
improves market efficiency.
    Recognizing this, the SEC encourages extensive discussion of the 
condition of the business in the MD&A. The SEC, in its 2003 MD&A 
Interpretive Release, stated ``[o]ne of the principal objectives of 
MD&A is to give readers a view of the company through the eyes of 
management by providing both a short- and long-term analysis of the 
business. To do this, companies should `identify

[[Page 29829]]

and address those key variables and other qualitative and quantitative 
factors which are peculiar to and necessary for an understanding and 
evaluation of the individual company'.'' In this regard, the SEC noted 
the importance of disclosures of key performance measures--``when 
preparing MD&A, companies should consider whether disclosure of all key 
variables and other factors that management uses to manage the business 
would be material to investors, and therefore required. These key 
variables and other factors may be non-financial, and companies should 
consider whether that non-financial information should be disclosed.'' 
The SEC went on to state that ``[i]ndustry-specific measures can also 
be important for analysis, although common standards for the measures 
also are important. Some industries commonly use non-financial data, 
such as industry metrics and value drivers. Where a company discloses 
such information, and there is no commonly accepted method of 
calculating a particular non-financial metric, it should provide an 
explanation of its calculation to promote comparability across 
companies within the industry. Finally, companies may use non-financial 
performance measures that are company-specific.'' \53\
---------------------------------------------------------------------------

    \53\ SEC, Commission Guidance Regarding Management's Discussion 
and Analysis of Financial Condition and Results of Operations, 
Securities Act Release No. 33-8350 (December 19, 2003) (2003 MD&A 
Interpretive Release).
---------------------------------------------------------------------------

    This discussion is intended to give information about the business 
in a way that is consistent with the manner in which the business is 
run.
Discussion
    The Subcommittee's hypothesis extends beyond a narrow definition of 
financial reporting to business reporting more generally. The 
Subcommittee has been evaluating whether public companies should 
increase their voluntary disclosure of financial and non-financial 
performance measures or indicators, such as KPIs. The Subcommittee has 
examined the current practices of public companies and notes that many 
companies are already disclosing some company-specific KPIs in their 
periodic reports filed with the SEC or in other public statements, but 
these company-specific measures may not necessarily be consistently 
reported by companies from period-to-period, are not necessarily well-
defined, and may not be commonly used by other companies in the same 
industry so that they lend themselves to comparisons between and among 
companies. Therefore, as part of its review of KPI disclosure, the 
Subcommittee has evaluated the kinds of KPIs that should be made 
available, in what format, and whether they should be consistently 
defined over time. The Subcommittee has found that various groups, 
within and outside industries, are working on developing industry-
specific and activity-specific KPIs in order to improve comparability 
of companies on an industry basis.
    In developing its preliminary hypothesis on KPIs and other possible 
metrics to enhance business reporting, the Subcommittee consulted with 
industry members and others who have been working on this subject. As a 
result of these discussions and its evaluation of other materials, the 
Subcommittee preliminarily believes that further exploration of the use 
of KPIs and other metrics by public companies would be constructive.
    Accordingly, for KPI reporting to be most effective and improve 
user understanding, the Subcommittee is considering that the full 
Committee recommend that companies should consider the following to 
improve KPI disclosures.\54\
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    \54\ The Subcommittee notes that the SEC has provided guidance 
as to some of these matters as well in its 2003 MD&A Interpretive 
Release as discussed above. The SEC noted that ``[t]he focus on key 
performance indicators can be enhanced not only through the language 
and content of the discussion, but also through a format that will 
enhance the understanding of the discussion and analysis.''
---------------------------------------------------------------------------

     Understandability--The Subcommittee believes that a given 
KPI term, such as ``same store sales,'' would be most useful in 
evaluating the relevant industry or activity if it had a standard 
agreed definition in the industry. For that reason, as part of its 
preliminary hypothesis, the Subcommittee notes that the SEC should 
explore ways to encourage private initiatives in various industries for 
the development of standard KPI definitions. It is presumed that there 
would be some terms that would be macro in nature that companies from 
all industries would make use of and thus would be activity-based, but 
it is assumed that many KPI terms would be industry-specific. Once a 
term has been defined by industry, the SEC and other global regulators 
should work with industry to support the use of such term in periodic 
and other company reports, with such modified or additional disclosures 
as the SEC and other global regulators deem necessary or appropriate. 
Companies should be encouraged to use such industry-defined terms and 
to disclose any differences in their use of terms from any industry-
defined and accepted definition. Companies would still have the freedom 
to use whatever terms they wished in describing their businesses but 
would be expected to make clear any differences between their 
definitions and those that have been industry defined.
     Consistency--Whether or not a company uses an industry-
defined term for its KPI disclosures, the KPI that is used should be 
reported consistently from period-to-period. Any changes in the 
definition of a KPI should be disclosed, along with the reasons for the 
change. KPIs should be reported not just for the current period but for 
prior periods as well so that investors can assess the company's 
development from period-to-period or year-to-year.
     Relevancy--KPI that are disclosed should be important to 
an understanding and tracking of the business or business segments for 
which they are used and should align with how reporting companies run 
their business.
     Presentability--When companies disclose KPIs in their 
reports and other releases, they should make clear to ordinary 
investors that the information is intended to provide information about 
the business of the company that is separate from and supplemental to 
the financial statements. This could either be done in a separate KPI 
section in MD&A or in subsections of parts of the MD&A, such as the 
general business discussion or the discussion by business segment. 
Segment reporting of KPIs, given the logical connection to business 
line activities, could be very useful. The inclusion of tabular 
presentations showing current and prior periods should be seriously 
considered.
     Comparability--Encouraging companies to use industry-
defined KPI's would enable investors to compare companies within and 
across industries and would also be quite useful at the industry 
segment level. Once industry-defined KPIs are available, the 
Subcommittee would hope that investor interest would encourage 
companies to use commonly defined KPI terms.
    The Subcommittee has heard that some companies may be hesitant 
about increased disclosure of KPIs because of concern that disclosure 
of these metrics may compromise competitive information.\55\ Neither 
the Subcommittee nor investors want companies to give away the ``crown 
jewels.'' The Subcommittee has also heard questions about the validity 
of many of such competitive harm claims, particularly where information 
is widely known within a particular

[[Page 29830]]

industry. The Subcommittee has heard that there is already so much 
information about companies that disclosure of unique competitive 
information would be rare. Nevertheless, the Subcommittee preliminarily 
believes that if a particular KPI could require the disclosure of 
competitively important information, the affected company could decline 
to disclose it.
---------------------------------------------------------------------------

    \55\ The Subcommittee also heard a question as to the liability 
treatment of KPIs.
---------------------------------------------------------------------------

    In an ideal disclosure system, non-financial and financial 
indicators and elements would be presented within a cohesive framework 
that combines KPIs and other indicators with GAAP data and text 
discussion in order to create a complete picture of a company. At this 
time, the Subcommittee believes that having the Committee propose to 
mandate or suggest such an organized structure is outside the scope of 
what the Subcommittee is evaluating, might be premature and 
inappropriate for a regulator or standard setter, possibly being too 
prescriptive.
    Rather, the Subcommittee's preliminary hypothesis believes that the 
SEC should encourage an industry driven initiative with significant 
investor involvement to develop best practices that companies could 
follow in developing and disclosing KPIs. Just as financial reporting 
standards and the recently developed XBRL taxonomy may improve business 
reporting by creating standardized language, the Subcommittee believes 
the development of a KPI dictionary, developed on an industry basis but 
also allowing for company-specific definitions, also could provide 
valuable information to investors.
    Thus, the Subcommittee has developed a preliminary hypothesis that 
is based on a number of industry-driven initiatives, with significant 
investor involvement, to develop best practices and common definitions 
for KPIs that companies could follow in disclosing KPIs. The hypothesis 
suggests that companies, investors, and business reporting consortiums 
should work together to develop industry-wide and activity-specific 
KPIs that conform to uniform or standard definitions, as well as 
company-specific KPIs. These KPIs should then be disclosed in a 
company's periodic reports, as well as other disclosure formats such as 
earnings releases. The hypothesis suggests that the KPIs:
     Be clearly and consistently defined to allow investors 
understanding of the meanings of the KPIs;
     Be disclosed, as relevant, on a company and/or segment 
basis; and
     Permit cross-company and cross-industry comparisons.
    The Subcommittee does not believe that the mandatory reporting of 
KPIs is desirable at this time. Instead, the Subcommittee believes that 
the Committee should consider encouraging the SEC to promote the 
development of commonly recognized and defined KPIs by industry groups.
Integration With Other Proposals
    The Subcommittee preliminarily believes that the formalization of 
KPI disclosures through commonly recognized definitions, will enhance 
the benefits that will come from other proposals from the Committee. 
For example, disclosing KPIs on company Web sites would allow investors 
and other users of the reported information to gain an improved 
understanding of the prospects for a company and could lead to better 
capital market pricing.

V. Improved Quarterly Press Release Disclosures and Timing

Preliminary Hypothesis 2

    Industry groups, including the National Investor Relations 
Institute, FEI, and the CFA Institute should update their best 
practices for earnings releases. Such updated best practices guidance 
should cover, among other matters, the type of information that should 
be provided in earnings releases and the need for investors to receive 
information that is consistent from quarter to quarter, with an 
explanation of any changes in disclosures from quarter to quarter. 
Further, the best practices guidance should consider recommending that 
companies include in their earnings releases the income statement, 
balance sheet and cash flow tables, locate GAAP reconciliations in 
close proximity to any non-GAAP measures presented, and provide more 
industry and company specific key performance indicators.
    The SEC should consider reinforcing its view that disclosures in 
connection with earnings calls posted on company Web sites should be 
maintained and available on such sites for at least 12 months.
Background
    As noted in the Progress Report, the quarterly earnings release, 
often the first corporate communication about the result of the quarter 
just ended, is viewed as an important corporate communication. This 
communication often receives more attention than the formal Form 10-Q 
submission which often occurs a week or two later.
    The quarterly earnings release is not currently required to contain 
mandated information other than that required by the application of 
Regulation G to the presentation of non-GAAP measures and the antifraud 
provisions of the federal securities laws. Industry groups have 
previously coordinated in developing best practices for reporting 
companies to follow in preparing their earnings releases. In addition, 
under SEC rules, companies must furnish earnings releases to the 
Commission on a Form 8-K. Investors and other market participants have 
expressed concern about the matters relating to earnings releases, 
including consistency of information provided in such releases, the 
timing of such releases in relation to the filing of the applicable 
periodic report, and the inclusion of earnings guidance in such 
earnings releases.
Discussion
    The Subcommittee has been examining a number of issues relating to 
the earnings release, including with regard to its consistency, 
understandability, timeliness, and the continued public availability of 
earnings conference calls. The Subcommittee had an opportunity to 
discuss the quarterly earnings release and these related matters with 
investor and company representatives. In addition, the Subcommittee 
considered the consistent provision of income statement, balance sheet 
and cash flow tables in the quarterly earnings release as well as the 
positioning and prominence of GAAP and non-GAAP figures, GAAP 
reconciliation, the consistent placement of topics, and clear 
communication of any changes to accounting methods or key assumptions. 
The Subcommittee viewed the goal for the earnings release to be a 
consistent, reliable communication form that all investors can easily 
navigate.
    The Subcommittee also briefly discussed the advisability of 
requiring the issuance of the earnings releases on the same day that 
the periodic report (e.g., Form 10-Q) is filed, in contrast to the 
current practice in which the earnings release often is issued before 
the periodic report is filed. The Subcommittee heard from company and 
investor representatives in this regard and took note of the comments 
that the SEC received in connection with a prior request for comment to 
tie the filing of the quarterly report to the issuance of an earnings 
release. The Subcommittee understood that the practices of companies in 
this regard may differ depending on the size of the company and the 
company's own disclosure practices. For example, the Subcommittee 
understands that some large companies issue their earnings release at 
the same time as the filing of

[[Page 29831]]

their quarterly reports. The Subcommittee also heard that smaller 
companies tended to wait to issue their earnings releases so that their 
news would not be eclipsed by news of larger and more well followed 
companies. While investors noted an interest in having the earnings 
release issued at the same time as the Form 10-Q is filed to avoid 
duplication of effort in analyzing the company's disclosures, 
representatives of companies and others expressed concern about the 
effect of delays in disclosing material non-public information about 
the quarter or year end. Investors also expressed concern regarding the 
trading of company stock by executives after the issuance of the 
earnings release but before the filing of the Form 10-Q and questioned 
whether executives could be prohibited from engaging in trading until 
after the Form 10-Q was filed.
    The Subcommittee determined not to include a preliminary hypothesis 
that would change current market practice regarding the issuance of 
earnings releases but would suggest that, instead, the SEC monitor 
company practices in regard to the timing of the earnings release in 
relation to the filing of the relevant periodic report with the SEC.
    The Subcommittee also heard concerns that companies were not 
keeping their earnings calls and related information posted on their 
Web sites for more than one quarter after the call, thus making 
quarterly comparisons difficult. The Subcommittee noted that the SEC 
had suggested that companies keep their Web site disclosures regarding 
GAAP reconciliations for non-GAAP measures presented on earnings calls 
available on their Web sites for at least a 12-month period and the 
Subcommittee's preliminary hypothesis would suggest that the SEC 
reiterate this guidance.\56\
---------------------------------------------------------------------------

    \56\ See SEC Conditions for Use of Non-GAAP Measures, Exchange 
Act Release No. 34-47226 (Jan. 22, 2003).
---------------------------------------------------------------------------

    The Subcommittee briefly discussed the practices of some companies 
in providing earnings guidance or public projections of next quarter's 
earnings by company officials, since some believe that this practice is 
an important underlying source of reporting complexity and other 
accounting problems. The Subcommittee also discussed the provision of 
annual guidance that may be updated quarterly. The Subcommittee does 
not intend to continue its evaluation of quarterly earnings guidance or 
to suggest any preliminary hypothesis regarding the provision of 
quarterly earnings guidance at this time because it notes that many 
others are evaluating the issues arising from the provision of 
quarterly earnings guidance.

VI. Use of Executive Summaries in Exchange Act Periodic Reports

Preliminary Hypothesis 3

    The SEC should mandate the inclusion of an executive summary in the 
forepart of a reporting company's filed annual and quarterly reports. 
The executive summary should provide summary information, in plain 
English, in a narrative and perhaps tabular format of the most 
important information about a reporting company's business, financial 
condition, and operations. As with the MD&A, the executive summary 
should be required to use a layered approach that would present 
information in a manner that emphasizes the most important information 
about the reporting company and include cross-references to the 
location of the fuller discussion in the annual report. The requirement 
for the executive summary should build on the company's MD&A overview 
and essentially be principles-based, other than a limited number of 
required disclosure items such as:
     A summary of a company's current financial statements;
     A digest of the company's GAAP and non-GAAP KPIs (to the 
extent disclosed in the company's 10-Q or 10-K);
     A summary of key aspects of company performance;
     A summary of business outlook;
     A brief description of the company's business, sales and 
marketing; and
     Page number references to more detailed information 
contained in the document (which, if the report is provided 
electronically, could be hyperlinks).
Background
    Reporting companies are not currently required to include any type 
of summary in their periodic reports, although a summary of the company 
and the securities it is offering is a line-item disclosure in 
Securities Act registration statements. Companies, therefore, are 
familiar with the concept of summarizing the important aspects of their 
business and operations at the time they are raising capital. The 
Subcommittee has heard that retail investors find it difficult at times 
to navigate through a company's periodic reports, including its Form 
10-K annual report. The Subcommittee has been evaluating the use of an 
executive summary in the forepart of a company's annual and quarterly 
Exchange Act reports to facilitate the ready delivery of important 
information to investors by providing them a roadmap of the disclosures 
contained in such reports.
Discussion
    The Subcommittee has been exploring a requirement to include an 
executive summary in reporting company annual and quarterly Exchange 
Act reports (Forms 10-K and 10-Q). The Subcommittee has met with 
investor and company representatives as well as securities counsel. The 
Subcommittee understands that a summary report prepared on a stand-
alone basis would not necessarily provide investors with information 
they need in a desired format and that investors would not use such a 
summary. However, the Subcommittee understands that an executive 
summary included in the forepart of an Exchange Act periodic report may 
provide investors, particularly retail investors, with an important 
roadmap to the company's disclosures located in the body of such a 
report.\57\ The executive summary in the Exchange Act periodic report 
would provide summary information, in plain English, in a narrative and 
perhaps tabular format of the most important information about a 
reporting company's business, financial condition, and operations. As 
with the MD&A, the executive summary would use a layered approach that 
would present information in a manner that emphasizes the most 
important information about the reporting company and include cross-
references to the location of the fuller discussion in the annual 
report.
---------------------------------------------------------------------------

    \57\ Such reports generally are posted on company Web sites as 
well so that the executive summaries would be electronically 
available with hyperlinks to the more detailed information in the 
relevant report.
---------------------------------------------------------------------------

    As noted in the Progress Report and as contemplated in the 
Subcommittee's preliminary hypothesis, the goal of the executive 
summary would be to help investors fundamentally understand a company's 
businesses and activities through a relatively short, plain English 
presentation. An executive summary in a periodic report may be most 
useful if it includes high-level summaries across a broad range of key 
components of the annual or quarterly report, rather than detailed 
discussion of a limited number of variables. The executive summary 
approach may be an efficient way to provide all investors, including 
retail investors, with a concise overview of a company, its business, 
and its financial condition. For the more sophisticated investor, an 
executive summary may be

[[Page 29832]]

helpful in presenting the company's unique story which the 
sophisticated investor could consider as it engages in a more detailed 
analysis of the company, its business and financial condition.
    The executive summary in a periodic report should be brief, and it 
might fruitfully build on the overview that the SEC has identified 
should be in the forepart of the MD&A disclosure. The MD&A overview is 
expected to ``include the most important matters on which a company's 
executives focus in evaluating the financial condition and operating 
performance and provide context.'' \58\ The executive summary should 
build on the MD&A overview disclosure and include the following:
---------------------------------------------------------------------------

    \58\ See 2003 MD&A Interpretive Release above.
---------------------------------------------------------------------------

    1. A summary of a company's current financial statements;
    2. A digest of the company's GAAP and non-GAAP KPIs (to the extent 
disclosed in the company's 10-Q or 10-K);
    3. A summary of key aspects of company performance;
    4. A summary of business outlook;
    5. A brief description of the company's business, sales and 
marketing;
    6. Page number references to more detailed information contained in 
the document (which, if the report is provided electronically, could be 
hyperlinks).
    The Subcommittee's preliminary hypothesis provides that the 
executive summary should be required to be included in the forepart of 
a reporting company's annual or quarterly report filed with the SEC or, 
if a reporting company files its annual report on an integrated basis 
(the glossy annual report is provided as a wraparound to the filed 
annual report), the executive summary instead could be included in the 
forepart of the glossy annual report. If the executive summary was 
included in the glossy annual report, it would not be considered filed 
with the SEC. The Subcommittee understands that the inclusion of a 
summary in the body of the periodic report should not give rise to 
additional liability implications.

VII. Continued Need for Improvements in the MD&A and Other Public 
Company Financial Disclosures

    The Committee noted in chapter 4 of the Progress Report that while 
investors and other market participants believe that while there has 
been some improvement in the MD&A disclosures since publication of the 
SEC's interpretive release in 2003, significant improvement is still 
needed. The Subcommittee evaluated the MD&A and other public company 
disclosures in the context of its preliminary hypotheses regarding 
disclosures of key performance indicators, earnings releases, and use 
of executive summaries in periodic reports.

[FR Doc. E8-11276 Filed 5-21-08; 8:45 am]

BILLING CODE 8010-01-P
