Progress Report of the SEC Advisory Committee on Improvements to Financial Reporting.

Federal RegisterFeb 28, 2008

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SECURITIES AND EXCHANGE COMMISSION

[Release Nos. 33-8896; 34-57331; File No. 265-24]

Progress Report of the SEC Advisory Committee on Improvements to Financial Reporting.

AGENCY:

Securities and Exchange Commission.

ACTION:

Request for comments.

SUMMARY:

The Advisory Committee is publishing its progress report and is soliciting public comment. The progress report contains the Committee's developed proposals, conceptual approaches, and matters for future considerations on improving the financial reporting system in the United States.

DATES:

Comments should be received on or before March 31, 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 message 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 Committee's progress report. The full text of this progress report is attached and also may be found on the Committee's web page at

http://www.sec.gov/about/offices/oca/acifr.shtml

. The progress report contains the Committee's developed proposals, conceptual approaches, and matters for future considerations on improving the financial reporting system in the United States. This progress report has been approved for issuance by the Committee. It does not necessarily reflect any position or regulatory agenda of the Commission or its staff.

All interested parties are invited to comment on the enclosed progress report. Comments on the progress report are most helpful if they (1) indicate the specific paragraph and/or page number 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, § 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: February 14, 2008.

Nancy M. Morris,

Committee Management Officer.

Appendix

Progress Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission

February 14, 2008

Progress Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission

Table of Contents

Transmittal Letter

Executive Overview

Introduction

Chapter 1: Substantive Complexity

Chapter 2: Standards-Setting Process

Chapter 3: Audit Process and Compliance

Chapter 4: Delivering Financial Information

Appendices

A—Separate Statement of Mr. Wallison

B—Examples of Substantive Complexity

C—Committee Members, Official Observers, and Staff

SEC Advisory Committee on Improvements to Financial Reporting, Washington, DC 20549

February 14, 2008

The Honorable Christopher Cox

Chairman

Securities and Exchange Commission

100 F Street, NE., Washington, DC 20549-1070

Dear Chairman Cox:

It is my pleasure and privilege to present to you, and the other Commissioners, on behalf of the Advisory Committee on Improvements to Financial Reporting, a progress report of the Committee's developed proposals, conceptual approaches, and currently identified matters for future consideration.

Our Committee has worked diligently to provide an interim progress report to you. The developed proposals in our progress report are proposals that we believe could be implemented by the Commission, its staff, or other bodies, as appropriate. These 12 proposals are summarized in the executive overview of our progress report. Conceptual approaches represent our initial views, which are based on discussions on a particular subject, but which require additional vetting before formalization into a developed proposal. Matters for future consideration are areas in which deliberations and research have not yet begun. After the conclusion of the Committee's work later this year, we will issue a final report with written recommendations.

We commend the Commission for its initiative in creating the Committee. You have been generous in furnishing staff and other resources. We would like to thank the staff members whose participation was invaluable during this phase of the Committee's work. These include from the Commission staff:

Conrad Hewitt

John W. White

James Daly

Bert Fox

Stephanie Hunsaker

Nili Shah

Brett Williams

James Kroeker

Wayne Carnall

Adam Brown

Todd E. Hardiman

Shelly Luisi

Amy Starr

These also include Russell Golden, Holly Barker and Christopher Roberge

from the Financial Accounting Standards Board and Sharon Virag from the Public Company Accounting Oversight Board.

We also want to thank our Official Observers whose participation and counsel have been invaluable to the Committee during this time:

Robert Herz

Kristen Jaconi

Mark Olson

Charles Holm

Phil Laskawy

We look forward to working with the Committee staff and Official Observers in the coming months as we develop our final report and recommendations.

Respectfully submitted on behalf of the Committee,

/s/ Robert C. Pozen

Robert C. Pozen

Committee Chairman

cc: Commissioner Paul S. Atkins

Commissioner Kathleen L. Casey

Members and Official Observers of the Committee

Conrad Hewitt

John White

James L. Kroeker

Nancy M. Morris

Executive Overview

This report has been approved by the Committee and reflects the views of a majority of its members. It does not necessarily reflect any position or regulatory agenda of the Commission or its staff.

In July 2007, the U.S. Securities and Exchange Commission (SEC or Commission) chartered the Advisory Committee on Improvements to Financial Reporting (Committee). The Committee's assigned objective is to examine the U.S. financial reporting system in order to make recommendations intended to increase the usefulness of financial information to investors,

while reducing the complexity of the financial reporting system to investors, companies, and auditors.

The term “investor(s)” is used throughout this progress report to refer to investors, creditors, rating agencies, and other users.

After the conclusion of our work, we will issue a final report with written recommendations to the Chairman of the SEC. In order to maximize our effect, we intend to issue a limited number of focused recommendations that address acknowledged problem areas and that we believe can be adopted without legislation, rather than attempting to address all perceived shortcomings in the financial reporting system.

All Committee members present at our February 11, 2008 meeting voted unanimously to issue to the Chairman of the SEC this progress report of the Committee's developed proposals, conceptual approaches, and currently identified matters for future consideration and to publish the progress report in order to encourage public feedback. Developed proposals are proposals that we believe could be implemented by the Commission, its staff,

or other bodies, as appropriate; these are summarized in the second part of this executive overview. Conceptual approaches represent our initial views, which are based on discussions on a particular subject, but which still require additional vetting before formalization into a developed proposal. Matters for future consideration are areas in which deliberations and research have not yet begun.

We note that some of our developed proposals, conceptual approaches, and matters for future considerations may require SEC action, while others may be implemented by SEC staff. We have, however, generally adopted a convention of addressing these areas to the SEC for convenience. We leave the determination of whether the proposals require SEC or SEC staff action to the discretion of the SEC and its staff.

This progress report represents our work to date, which has included four public meetings where these topics were deliberated by the full Committee. In generating this progress report, we also considered all of the public comments received to date on our work.

All of the developed proposals, conceptual approaches and matters for future consideration were adopted unanimously (except for one dissenting vote on one proposal, as noted herein, which resulted in one separate statement from Mr. Wallison, attached as appendix A of this progress report).

Comments to the Committee are available at

http://www.sec.gov/comments/265-24/265-24.shtml.

We have and continue to welcome feedback at any time from investors, registrants, auditors, and others on our work. Information on how to submit comments is available at:

http://www.sec.gov/about/offices/oca/acifr.shtml.

We explain each of our developed proposals, conceptual approaches and matters for future consideration in the body of this progress report. The progress report is organized by the topics considered by the four subcommittees that were created in order to research, develop, and propose preliminary recommendations to the full Committee for discussion and decision-making. Thus, chapter one is on substantive complexity; chapter two on the standards-setting process; chapter three on audit process and compliance; and chapter four on delivery of financial information. Later in 2008, we will also identify and analyze some of the issues involved with the potential movement from a U.S.-based accounting regime to a global accounting system.

This executive overview highlights the key themes that tie together the chapters in this progress report, with a few examples to illustrate each theme.

The main themes are:

We wish to emphasize that the examples we give are illustrative only. We do not mean to imply any order of priority.

1. Increasing emphasis on the investor perspective in the financial reporting system.

2. Consolidating the process of setting and interpreting accounting standards.

3. Promoting the design of more uniform and principles-based accounting standards.

4. Creating a disciplined framework for the increased use of professional judgment.

5. Taking steps to coordinate generally accepted accounting principles in the U.S. (GAAP) with international financial reporting standards (IFRS).

I. Themes

I.A. Investor Perspective

The current system of financial reporting, including the process by which financial reporting standards are developed, attempts to balance the interests of relevant parties such as preparers, auditors, and investors. In practice, however, the system has sometimes been more responsive to the interests of preparers and auditors than to the needs of investor groups.

We believe that the financial reporting system should give pre-eminence to the needs of investors, while not ignoring the interests of other relevant parties. In this regard, we propose that investors be better represented on the Financial Accounting Standards Board (FASB) and the Financial Accounting Foundation (FAF). We also propose that the determination of how to correct financial statement errors should be based on the needs of current investors, who should, in any event, be provided with more disclosure regarding such errors.

With regard to the delivery of financial information, we propose that the SEC clarify certain legal issues related to the use of company websites as a vehicle for providing useful information to different types of investors in order to facilitate creative methods to present such information, such as in tiered formats. We also propose a gradual phase-in of interactive disclosure technology (i.e., XBRL-tagging) to facilitate the ability of investors to more easily access comparative arrays of company

information, while minimizing the burdens on preparers (especially smaller companies). A phase-in approach would allow for enhanced understanding of the technology, proven use of the new XBRL U.S. GAAP Taxonomy, and further development of tagging and rendering software.

I.B. Setting Standards and Interpretative Process

The current financial reporting system is characterized by a large volume of standards, including individual standards that are too long or complicated; interpretations; and detailed application guidance from a variety of public and private sources. This volume and complexity have led to concerns about whether the FASB is following appropriate priorities within a consistent conceptual framework in adopting standards, and whether investors, preparers, and auditors can efficiently find the complete body of authoritative literature on an accounting issue.

While the FASB has made considerable progress in addressing both concerns, we believe that certain measures are needed to enhance the process for adopting new standards and issuing interpretations of existing standards.

For example, we propose that the FASB should set explicit priorities based on consultation with an Agenda Advisory Group, which would include representatives of the SEC and the Public Company Accounting Oversight Board (PCAOB), as well as representatives from the investor, preparer, and auditor communities. Further, the FASB should fully explain and expose for comment, in documents containing proposed significant new standards, its process for conducting cost-benefit studies, including field interviews and testing before finalizing any significant new accounting standard. Also, we propose that the FASB, with input from the Agenda Advisory Group, should conduct periodic assessments of existing standards to determine if they are operating as intended.

We recognize that the FASB has processes that are moving in the direction of the objectives underlying our interim developed proposals. We look forward to further discussion with the FASB to evaluate whether additional improvements would more effectively achieve the desired objectives. We plan to consider this dialogue in making final recommendations for process enhancements to the U.S. standards-setter.

With the implementation of these proposals, we propose that the FASB should be, to the extent practicable, the sole standards-setter for GAAP and the primary source of broad interpretations of existing accounting standards. The FASB should perform these functions with a high degree of independence, but it should coordinate closely with the SEC, including through the proposed Agenda Advisory Committee. When it is necessary for the SEC to issue broadly applicable interpretations, we are considering the manner in which the SEC develops and communicates those interpretations. Nevertheless, we believe the SEC should continue to provide comments on registrant-specific matters, but these comments should not be viewed as broadly applicable. We propose that the authoritative source of GAAP should be limited, as much as possible, to the contents of the FASB's codification project, which will be updated on a regular basis.

I.C. Design of Standards

GAAP contains many detailed rules with several industry-specific exceptions and alternative accounting policies for the same transaction. Moreover, some of these rules have all-or-nothing results, which stem from bright line tests. This combination allows companies and auditors to reach a technically compliant conclusion that may be inconsistent with the underlying economic substance of the transaction, thereby potentially undermining an investor's complete and accurate understanding of the transaction. For example, transactions involving the right to use an asset for a promise to pay a series of payments in the future can be kept off a company's balance sheet if detailed rules are followed.

In response, we propose that the FASB move away from industry-specific guidance to activity-based guidance (e.g., from banking as an industry to lending as an activity by any company) and strive to reduce the number of alternative ways available under GAAP to account for the same transaction. We also plan to consider, among other possibilities, the feasibility of proportionate recognition, rather than all-or-nothing results, to better reflect the rights conveyed by agreements and obligations incurred.

Some believe an increased use of fair value measurements will better portray the current valuation of past transactions and improve financial reporting. Others believe the increased use of fair value measurements will cause unnecessary volatility, will decrease the reliability of financial statements, and will only increase investor confusion. We plan to deliberate whether, among other approaches, to support the FASB's project to consider changing the income statement format into two or more groupings designed to help investors better understand the different sources of changes in a company's income—for example, by separating cash or accrued earnings from changes resulting from fluctuations in the fair value of assets such as publicly-traded bonds.

More broadly, we will consider recommending that the FASB design accounting standards with more general principles and fewer detailed rules in order to prevent the manipulation of technical requirements to reach pre-conceived accounting results.

I.D. Professional Judgment

The preparation and audit of financial statements have always required the use of judgment. The recent evolution of accounting requires even more judgment—for example, the more frequent use of fair value involves estimates of value that may be less objectively determined than historical cost measures. Similarly, the revised auditing standards recently issued by the PCAOB emphasize the need for professional judgment in taking a risk-based approach to performing internal control audits.

As noted above, we are about to study the merits of moving in the direction of more principles and fewer detailed rules. Also, as mentioned below, international accounting standards, as they exist today, contain less detailed guidance and fewer rules than GAAP. Detailed rules not only increase the complexity of the financial reporting system, but they also permit the structuring of transactions to achieve a particular accounting result, even if the results are inconsistent with the economic substance of the transactions or the underlying purposes of the rules.

In recognition of the increasing use of accounting judgment, we are making two developed proposals. First, we propose asking the FASB to conduct post-adoption reviews of significant new standards, generally within one to two years of their effective dates to ascertain the degree of diversity in practice in using judgment when applying those standards. If that diversity is too broad or otherwise inappropriate, we would expect the FASB to amend the standard or issue interpretative guidance.

Second, we propose that the SEC and PCAOB adopt frameworks for reviewing the exercise of judgment. The framework applicable to accounting judgments would require a disciplined process, including the identification of available alternatives, analysis of the relevant literature, review of the pertinent facts, and a well-reasoned explanation of the conclusions—all

documented contemporaneously with the making of the accounting judgment. We believe adoption of these frameworks would encourage executives and auditors to follow a disciplined process in making judgments, and thereby give investors more confidence in the ways in which accounting and auditing judgments are being exercised.

I.E. Global Convergence

At present, U.S. companies follow GAAP; in most other countries, publicly-traded companies are increasingly following IFRS as adopted by the International Accounting Standards Board (IASB). We support the long-term goal of converging GAAP with IFRS in order to reduce accounting costs to investors and others in an increasingly global business environment. But we recognize that there are various paths to convergence, and it may take years for full convergence to be achieved. Therefore, we believe that it is quite useful to propose enhancements to the financial reporting system in the U.S.

Later in 2008, we will identify and analyze some of the issues to be resolved in the move toward global convergence of accounting standards. At this time, we note that the principles contained in IFRS are less encumbered by detailed rules than GAAP; accordingly, GAAP will probably need to become less rules-based in order to promote the goal of global convergence. We also note that IFRS has little industry-specific guidance, and we encourage the IASB to continue in this manner, consistent with our proposal that the FASB issue activity-based standards rather than industry-specific accounting standards.

On the other hand, IFRS contains a number of alternative accounting policies for the same activity, and there are political pressures to add exceptions in certain countries. As part of the effort to promote global convergence, we urge the IASB to continue to reduce the number of alternative accounting policies currently available and to resist the political pressures for country exceptions.

II. Summary of Developed Proposals

Summarized below are our developed proposals based on our work to date. These developed proposals are discussed in greater detail in the remainder of this progress report. These developed proposals are numbered consecutively in this executive overview, with a reference in parentheses to their position in the body of the report.

1. GAAP should be based on business activities,

rather than industries. As such, the SEC should recommend that any new projects undertaken jointly or separately by the FASB be scoped on the basis of business activities rather than industries. Any new projects should include the elimination of existing industry-specific guidance in relevant areas as a specific objective of those projects, unless, in rare circumstances, retaining industry guidance can be justified on the basis of cost-benefit considerations (discussed in section II.A of chapter 1).

As discussed in section II.B of chapter 1 regarding management intent, we have not taken a position as to whether intent is an appropriate basis of accounting. Similarly, we express no view on whether intent provides a meaningful distinction between business activities.

The SEC should also recommend that, in conjunction with its current codification project, the FASB add a project to its agenda to remove or minimize existing industry-specific guidance that conflicts with generalized GAAP, taking into account the pace of convergence efforts.

(Chapter 1—developed proposal 1.1)

Some constituents understand “convergence” to mean that GAAP and IFRS (as published by the IASB) will eventually be harmonized, at which point no substantive differences will exist between the two bodies of accounting literature. Others understand it to mean a discrete transition from GAAP to IFRS at a specified date without respect to whether the two bodies of literature are substantially harmonized. The timing of these two approaches may differ, which would likely impact the prioritization of this proposal to eliminate existing U.S. industry-specific guidance on the FASB's agenda. In either case, we believe industry-specific guidance should be substantially eliminated prior to convergence—either as a component of the convergence plan, or by establishing a specified date after which the use of industry-specific guidance would be prohibited.

2. GAAP should be based on a presumption that formally promulgated alternative accounting policies should not exist. The SEC should recommend that any new projects undertaken jointly or separately by the FASB not provide additional optionality, unless, in rare circumstances, it can be justified. Any new projects should include the elimination of existing alternative accounting policies in relevant areas as a specific objective of those projects, unless, in rare circumstances, the optionality can be justified. (Chapter 1—developed proposal 1.2)

3. Additional investor representation on standards-setting bodies is central to improving financial reporting. Only if investor perspectives are properly considered by all parties will the output of the financial reporting process meet the needs of those for whom it is primarily intended to serve. Therefore, the perspectives of investors should have pre-eminence. To achieve that pre-eminence in standards-setting, the SEC should encourage the following improvements:

• Add investors to the FAF to give more weight to the views of different types of investors, both large and small.

• Give more representation on both the FASB and the FASB staff to experienced investors who regularly use financial statements to make investment decisions to ensure that standards-setting considers fully the usefulness of the resulting information. (Chapter 2—developed proposal 2.1)

4. The SEC should assist the FAF with enhancing its governance of the FASB, as follows:

• By encouraging the FAF to develop performance metrics to assess the FASB's adherence to the goals in its mission statement, objectives, and precepts and to improve its efficiency.

• By supporting the FAF's changes outlined in its Request for Comments on Proposed Changes to Oversight, Structure and Operations of the FAF, FASB and GASB, with minor modifications regarding composition of the FAF and the FASB, as proposed in section II of chapter 2, and agenda-setting, as proposed in section IV of chapter 2.

• By encouraging the FAF to amend the FASB's mission statement, stated objectives, and precepts to emphasize that an additional goal should be to minimize avoidable complexity. (Chapter 2—developed proposal 2.2)

5. The SEC should encourage the FASB to further improve its standards-setting process and timeliness, as follows:

• Create a formal Agenda Advisory Group that includes strong representation from investors, the SEC, the PCAOB, and other constituents, such as preparers or auditors, to make recommendations for actively managing U.S. standards-setting priorities.

• Refine procedures for issuing new standards by: (1) Implementing investor pre-reviews designed to assess perceived benefits to investors, (2) enhancing cost-benefit analyses, and (3) requiring improved field visits and field tests.

• Improve review processes for new standards by conducting post-adoption reviews of every significant new standard, generally within one to two years of its effective date, to address interpretive questions and reduce the diversity of practice in applying the standard, if needed.

• Improve processes to keep existing standards current and to reflect changes in the business environment by conducting periodic assessments of

existing standards. (Chapter 2—developed proposal 2.3)

6. The number of parties that either formally or informally interprets GAAP and the volume of interpretative implementation guidance should continue to be reduced. The SEC should coordinate with the FASB to clarify roles and responsibilities regarding the issuance of interpretive implementation guidance, as follows:

• The FASB Codification, a draft of which was released for verification on January 16, 2008, should be completed in a timely manner. In order to fully realize the benefits of the FASB's codification efforts, the SEC should ensure that the literature it deems to be authoritative is integrated into the FASB Codification to the extent possible, or separately re-codified, as necessary.

• To the extent practical, going forward, there should be a single standards-setter for all authoritative accounting standards and interpretive implementation guidance that are applicable to a particular set of accounting standards, such as GAAP or IFRS. For GAAP, the FASB should continue to serve this function. To that end, the SEC should only issue broadly applicable interpretive implementation guidance in limited situations (see section VI of chapter 2).

• All other sources of interpretive implementation guidance should be considered non-authoritative and should not be required to be given more credence than any other non-authoritative sources that are evaluated using well-reasoned, documented professional judgments made in good faith. (Chapter 2—developed proposal 2.4)

7. The FASB or the SEC, as appropriate, should issue guidance reinforcing 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 quantitatively small error is material, qualitative factors also may lead to a conclusion that a quantitatively large error is not material. The evaluation of errors should be on a “sliding scale.”

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. (Chapter 3—developed proposal 3.1)

8. The FASB or the SEC, as appropriate, should issue guidance on how to correct an error consistent with the principles outlined below:

• 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 investor's assessment of the annual financial statements would not require restatement of the annual financial statements in which the error occurred, but would need to be disclosed in an appropriate document, and, to the extent that the error remains uncorrected in the current period, corrected 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 statements, 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.

• All errors, other than clearly insignificant errors, should be 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.

• The current disclosure during the period in which the restatement is being prepared, about the need for a restatement and about the restatement itself, is not consistently adequate for the needs of investors and should be enhanced. (Chapter 3—developed proposal 3.2)

9. 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 8 above. (Chapter 3—developed proposal 3.3)

10. The SEC should adopt a judgment framework for accounting judgments. The PCAOB should also adopt a similar framework with respect to auditing judgments. Careful consideration should be given in implementing any framework to ensure that the framework does not limit the ability of auditors and regulators to ask appropriate questions regarding judgments and take actions to require correction of unreasonable judgments.

The proposed framework applicable to accounting-related judgments would include the choice and application of accounting principles, as well as the estimates and evaluation of evidence related to the application of an accounting principle. We believe that a framework 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 important and would be beneficial to investors, preparers, and auditors. Therefore, we propose that the PCAOB develop a professional judgment framework for the application and evaluations of judgments made based on PCAOB auditing standards. (Chapter 3—developed proposal 3.4)

11. The SEC should, over the long-term, mandate the filing of XBRL-tagged financial statements after the satisfaction of certain preconditions relating to: (1) Successful XBRL U.S. GAAP Taxonomy testing, (2) capacity of reporting companies to file XBRL-tagged financial statements using the new XBRL U.S. GAAP Taxonomy on the SEC's EDGAR system, and (3) the ability of the EDGAR system to provide an accurately rendered version of all such tagged information. The SEC should phase in XBRL-tagged financial statements as follows:

• The largest 500 domestic public reporting companies based on unaffiliated market capitalization (public float) should be required to furnish to the SEC, as is the case in the voluntary program today, a document prepared separately from the reporting companies' financial statements that are filed as part of their periodic Exchange Act reports. This document would contain the following:

○ XBRL-tagged face of the financial statements.

To allow this first phase, the SEC EDGAR system must permit submissions using the new XBRL U.S. GAAP Taxonomy.

○ Block-tagged footnotes to the financial statements.

We understand that tagging beyond the face of the financial statements and block-tagging of footnotes, such as granular tagging of footnotes and non-financial data, may require significant effort and would involve a significant number of tags.

• Domestic large accelerated filers (as defined in SEC rules, which would include the initial 500 domestic public reporting companies) should be added

to the category of companies, beginning one year after the start of the first phase, required to furnish XBRL-tagged financial statements to the SEC.

• Once the preconditions noted above have been satisfied and the second phase-in period has been implemented, the SEC should evaluate whether and when to move from furnishing to the SEC to the official filing of XBRL-tagged financial statements with the SEC for the domestic large accelerated filers, as well as the inclusion of all other reporting companies, as part of a company's Exchange Act periodic reports. (Chapter 4—developed proposal 4.1)

A dissenting vote on developed proposal 4.1 was cast by Peter Wallison.

12. The SEC should issue a new comprehensive interpretive release regarding the use of corporate Web sites for disclosures of corporate information, which addresses issues such as liability for information presented in a summary format, treatment of hyperlinked information from within or outside a company's Website, treatment of non-GAAP disclosures and GAAP reconciliations, and clarification of the public availability of information disclosed on a reporting company's Web site.

Industry participants should coordinate among themselves to develop uniform best practices on uses of corporate websites for delivering corporate information to investors and the market. (Chapter 4—developed proposal 4.2)

We believe publication of this progress report will increase the chances of our recommendations being implemented. The developed proposals in this progress report are described with enough detail to enable the SEC and public commentators to evaluate whether regulatory action in these areas is warranted. The description of conceptual approaches in this progress report will hopefully stimulate discussion and debate on these topics so that we can put forward additional developed proposals later this

year.

This report has been approved by the Committee and reflects the views of a majority of its members. It does not necessarily reflect any position or regulatory agenda of the Commission or its staff.

Introduction

I. Our Objective

while reducing the complexity of the financial reporting system to investors, companies, and auditors.

The term “investor(s)” is used throughout this progress report to refer to investors, creditors, rating agencies, and other users.

More specifically, our charter identifies the following areas of inquiry:

• The current approach to setting financial accounting and reporting standards, including: (1) The principles-based versus rules-based standards, (2) the inclusion within standards of exceptions, bright lines, and safe harbors, and (3) the process for providing timely guidance on implementation issues and emerging issues.

• The current process of regulating compliance with accounting and reporting standards.

• The current system for delivering financial information to investors and accessing that information.

• Other environmental factors that drive avoidable complexity, including the possibility of being second-guessed, the structuring of transactions to achieve an accounting result, and whether there is a hesitance by professionals to exercise professional judgment in the absence of detailed rules.

• Whether there are current accounting and reporting standards that do not result in useful information to investors, or impose costs that outweigh the resulting benefits.

• Whether the growing use of international accounting standards has an impact on the relevant issues relating to the complexity of U.S. accounting and reporting standards and the usefulness of the U.S. financial reporting system.

II. Our Guiding Principles

We believe that financial reporting should provide information that aids investors in making investment, credit, and similar resource allocation decisions.

However, some argue that, over time, financial reporting has become a burdensome compliance exercise with decreasing relevance to investors. This effect can be attributed, in part, to: (1) The evolution of new business strategies and financing techniques that stretch the limits of what the traditional reporting framework can effectively convey, and (2) an overly litigious culture that, arguably, results in financial reporting designed as much to protect against liability as to inform investors. As a result, we believe the disconnect between current financial reporting and the information necessary to make sound investment decisions has become more pronounced.

Adapted from the FASB Preliminary Views document and IASB Discussion Paper, Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information (July 6, 2006), which states, “The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions.”

A key factor often cited as driving this disconnect is complexity, which has rarely been defined in the context of financial reporting. We have developed and applied the following definition of complexity in this context to guide our deliberations:

Definition of Complexity

The state of being difficult to understand and apply. Complexity in financial reporting refers primarily to the difficulty for:

1. Investors to understand the economic substance of a transaction or event and the overall financial position and results of a company.

2. Preparers to properly apply generally accepted accounting principles in the U.S. (GAAP) and communicate the economic substance of a transaction or event and the overall financial position and results of a company.

3. Other constituents to audit, analyze, and regulate a company's financial reporting.

Complexity can impede effective communication through financial reporting between a company and its stakeholders. It also creates inefficiencies in the marketplace (e.g., increased investor, preparer, audit, and regulatory costs) and suboptimal allocation of capital.

Causes of Complexity

The causes of complexity are many and varied. We have identified the following significant causes of complexity:

1. Complex activities—The increasingly sophisticated nature of business transactions can be difficult to understand, particularly with respect to the growing scale and scope of companies with operations that cross international boundaries and financial reporting regimes.

2. Incomparability and inconsistency—Incomparable reporting of activities within and across entities

arises because of factors such as exceptions to general principles, bright lines, and the mixed attribute model. Some of this guidance permits the structuring of transactions in order to achieve particular financial reporting results. Further, to the extent new pronouncements are adopted prospectively, past and present periods of operating results are not comparable. This is compounded by the rapid pace at which new accounting pronouncements are being adopted, which hinders the ability of all constituents to understand and apply new guidance in relatively short timeframes.

3. Nature of financial reporting standards—Standards can be difficult to understand and apply for several reasons, including:

• The existence of opposing points of view that were taken into account when developing standards—most importantly, the attempts by public companies to smooth amounts that vary from period to period, versus the requests from those who want such amounts marked to market each period.

• The challenge of describing accounting principles in simple terms (i.e., plain English) for highly sophisticated transactions.

• The presence of detailed guidance for numerous specific fact patterns.

• The impact of multiple bodies setting standards.

• The development of such standards on the basis of an incomplete and inconsistent conceptual framework.

4. Volume—The vast number of formal and informal accounting standards, regulations, and interpretations, including redundant requirements, make finding the appropriate standard or interpretation challenging for particular fact patterns.

5. Audit and regulatory systems that challenge the use of professional judgment—The risk of litigation and the fear of being “second-guessed” results in (1) a greater demand for detailed rules on how to apply accounting standards to an ever increasing set of specific situations, (2) unnecessary restatements that are not meaningful to investors, and (3) legalistic disclosures that are difficult to understand.

6. Educational shortcomings—Undergraduate and graduate education in accounting has traditionally emphasized the mechanics of double-entry bookkeeping, which favors the use of detailed rules rather than the full understanding of relevant principles. The same approach is evident in the certified public accountant exam, as well as continuing professional education requirements.

7. Information delivery—The need for information varies by investor type and is often driven by a legal, rather than an investor, perspective. In addition, the amount and timing of information, as well as the method by which it is transmitted, may result in complex and hard-to-navigate disclosures that cause investors to sort through material that they may not find relevant in order to identify pieces that are. These factors make it difficult to distinguish the sustaining elements of an entity from non-operating or other influences.

We observe that two types of substantive complexity exist: (1) Unavoidable complexity, which is a function of the underlying transaction or item being accounted for, such as the first cause of complexity noted above, and (2) avoidable complexity, which is introduced from other sources. Our focus is on avoidable complexity, with an emphasis on improvements that are feasible in the near-term.

III. Our Scope

We have limited our deliberations to matters involving SEC registrants. While financial reporting matters and, more specifically, GAAP, also apply to private entities, including nonprofit organizations, our focus is consistent with our role as an advisory committee to the SEC.

We have also focused our scope as it relates to international matters. The SEC recently amended its rules to eliminate the requirement for a GAAP reconciliation for foreign private issuers reporting under international financial reporting standards (IFRS) as issued by the International Accounting Standards Board (IASB), and issued a concept release to explore a more far-reaching prospect—the possibility of giving domestic issuers the alternative to report using IFRS. We have proceeded based on two premises: (1) That, despite any potential actions by the Commission to permit IFRS reporting by domestic issuers, GAAP will continue to be utilized by many U.S. public companies for a significant number of years, and (2) that the convergence process between GAAP and IFRS will continue. As a result, we believe it is productive to make recommendations on improving GAAP, as well as the related processes at the Financial Accounting Standards Board (FASB or the Board), the Public Company Accounting Oversight Board (PCAOB), and the SEC. At the same time, we will point out how our developed proposals can be coordinated with the work of the IASB and the development of IFRS, with the objective of promoting convergence.

IV. Our Approach

To facilitate the development of these recommendations, we have created subcommittees that report to the full Committee for discussion and deliberation. The subcommittees are:

1. Substantive Complexity.

2. Standards-Setting Process.

3. Audit Process and Compliance.

4. Delivering Financial Information.

Matters related to international coordination will be addressed, as appropriate, as part of our deliberations later in 2008.

The purpose of this progress report is to present our developed proposals, conceptual approaches, and matters for future considerations based on our work to date. Developed proposals are proposals that we believe could be implemented by the Commission, its staff,

or other bodies, as appropriate. Conceptual approaches represent our initial views, which are based on discussions on a particular subject, but which still require additional vetting before formalization into a developed proposal. Matters for future considerations are areas in which deliberations and research have not yet begun.

Our work to date has included four public meetings where these topics were deliberated by the full Committee. In generating this progress report, we also considered all of the public comments received to date on our work.

statement from Mr. Wallison, attached as appendix A of this progress report).

Comments to the Committee are available at

http://www.sec.gov/comments/265-24/265-24.shtml

. We have and continue to welcome feedback at any time from investors, registrants, auditors, and others on our work. Information on how to submit comments is available at:

http://www.sec.gov/about/offices/oca/acifr.shtml.

Chapter 1: Substantive Complexity

I. Introduction

Public companies in the U.S. submit financial statements to the SEC so investors can monitor their financial performance and make decisions about capital allocation. Traditionally, those financial statements are prepared using a common framework referred to as GAAP. A casual review of audited financial statements might create a perception that amounts reported in a balance sheet or income statement are mechanical and precise, when they in fact reflect a great deal of choices, estimation and judgment.

While ideally GAAP should provide clear and consistent guidance for preparing financial statements, this is not always true. A number of factors undermine this ideal, including the causes of complexity enumerated in the Introduction to this progress report. As a result, certain parts of GAAP may actually hinder effective comparison of financial performance between companies. For instance, a large company may purchase a smaller company to acquire a newly-developed patent that the smaller company obtained to protect a promising new product. In that scenario, the purchasing company would record the patent as an asset under GAAP. However, if the smaller company was not purchased, but continued developing the product on its own, it would be prohibited by GAAP from recording an asset to reflect the patent on its balance sheet.

This example is just one illustration of the avoidable complexity embedded in the current substantive standards of GAAP. We have identified what we consider to be the three most pressing forms of avoidable substantive complexity that currently exist in financial reporting: (1) Exceptions to general principles, (2) bright lines, and (3) the mixed attribute model that blends the use of fair value and historical cost.

Exceptions to general principles create complexity because they deviate from established standards that are applicable to most companies. In effect, investors and preparers no longer speak a uniform language to communicate financial information; they must learn new dialects. Other constituents in that communication process are similarly impacted. Our work in this area is divided into four categories. First, there are many examples of industry-specific guidance, some of which conflict with more generalized GAAP that applies across most industries.

Second, alternative accounting policies give preparers options among acceptable practices, such as whether or not to apply hedge accounting,

which reduce comparability across companies. Third, scope exceptions other than industry-specific guidance represent departures from a principle and require detailed analyses to determine whether they apply. Fourth, competing models create requirements to apply different accounting models to similar types of transactions or events, depending on the balance sheet or income statement items involved. This diversity requires all constituents to understand assorted implementation methods, even though they are based on similar fundamental principles.

See comparison of Statement of Financial Accounting Standard (SFAS) No. 51, Financial Reporting by Cable Television Companies, with SEC Staff Accounting Bulletin (SAB) 104, Revenue Recognition (as codified in SAB Topic 13), later in this chapter.

Hedge accounting guidance is provided in SFAS No. 133, Accounting for Derivatives and Hedging Activities.

Bright lines are problematic because they create superficial borders along a continuous spectrum of transactions. More fundamentally, certain reporting standards require drastically different accounting treatments on either side of a bright line. Lease accounting is often cited as an illustration of bright lines. 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,

where a mere 1% difference leads to very different accounting.

See discussion of bright lines below for further details.

The mixed attribute model results in amounts that are a blend of accounting conventions. Some assets and liabilities are measured at historic cost, others at lower of cost or market, and still others at fair value. Combinations or subtotals of these numbers thus may not be intuitively useful to investors. While some advocate using fair value for the entire balance sheet as a solution, this would exacerbate the existing questions about relevance and reliability, including considerable subjectivity in the valuation of thinly-traded assets and liabilities.

The remainder of this chapter discusses each of these areas and the manner in which they contribute to complexity in greater depth. It also contains developed proposals or conceptual approaches to reduce their effects. The sequence in which these areas are presented does not necessarily indicate their relative priority to one another. Rather, certain areas warrant additional research and deliberation before reasonable proposals can be fully developed, such as those related to the mixed attribute model and more meaningful groupings of individual line items on the financial statements. We intend to pursue these topics during the course of our work later in 2008. Lastly, while deliberations have been conducted primarily in the context of GAAP, we believe that our analyses and proposals are similarly applicable under IFRS.

II. Exceptions to General Principles

II.A. Industry-Specific Guidance

Developed Proposal 1.1: GAAP should be based on business activities,

As discussed in section II.B of this chapter regarding management intent, we have not taken a position as to whether intent is an appropriate basis of accounting. Similarly, we express no view on whether intent provides a meaningful distinction between business activities.

Background

Industry-specific guidance refers to: (1) Exceptions to general accounting standards for certain industries, (2) industry-specific guidance created in the absence of a single underlying standard or principle, and (3) industry practices not specifically addressed or based in GAAP. Industries covered by this guidance include, but are not limited to, the insurance, utilities, oil and gas, mining, cable television, financial, real estate, casino, broadcasting, and film industries.

Refer to appendix B for additional examples.

Industry-specific guidance has developed for a number of reasons. These include multiple standards-setters issuing guidance without consistently coordinating their efforts, a desire to enhance uniformity throughout an industry, and efforts to customize accounting standards for allegedly “special” transactions or investor needs. In some cases, industries have developed their own practices in the absence of applicable authoritative literature.

Industry-specific guidance contributes to avoidable complexity by making financial reports less comparable.

This is evident across industries, when conflicting accounting models are used for similar or identical transactions. It may also be used as an improper analogy to achieve desired results or to require more conservative accounting treatments (e.g., by auditors).

In addition, the use of an industry to define an accounting treatment raises serious questions about which companies are within the scope of specific guidance. This issue is especially pronounced for diversified companies, which may be involved in a number of different industries.

As noted previously in the 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):

The proliferation of specialized industry standards creates two problems that can hinder standard setters' efforts to issue subsequent standards using a more objectives-oriented regime.

• The existence of specialized industry practices may make it more difficult for standard setters to eliminate scope exceptions in subsequent standards (e.g., many standards contain exceptions for insurance arrangements subject to specialized industry accounting)

• The specialized standards may create conflicting GAAP, which makes it more difficult for accounting professionals to determine the appropriate accounting.

For instance, some auditors may use concepts in revenue recognition from the software industry (Statement of Position (SoP) 97-2) as a basis for postponing the revenue recognition of companies in other industries without on-point literature. Opponents of this practice argue such revenue deferral is too conservative and does not adequately portray the extent to which a company may have satisfied its product or service obligations in a long-term or multiple-element contract.

Further, industry-specific guidance unnecessarily increases the volume of accounting literature. This, in turn, adds to the costs of implementing such literature and maintaining it (e.g., monitoring it for interaction with other new and existing standards and expanding the size and scope of technical resources and databases). Industry-specific guidance also increases the cost of training accountants and retaining industry experts, while compounding the complexity that investors experience in understanding the present variety of accounting and disclosure standards. Lastly, it hinders more widespread use of XBRL by increasing the number of data tags that need to be created, maintained, and properly used to deliver financial information.

On the other hand, industry-specific guidance may alleviate complexity by allowing industry reporting to better meet the specific investor needs in that industry and enhancing comparability across entities within an industry. Further, it may depict important differences in the economics of an industry, particularly where application of a generalized principle may not result in accounting that is faithful to a transaction's substance. We also note that historically, some industry-specific guidance has filled a need where GAAP is otherwise lacking, and simplified or reduced the amount of guidance a preparer in an industry would need to consider (even though it might increase complexity across industries generally). Finally, specialized guidance has been able to address prevalent industry issues quickly because it was written for a narrower audience than generalized GAAP.

Industry-specific guidance can be broken into three categories. First, some industry-specific guidance is explanatory in nature and consistent with generalized GAAP, such as portions of AICPA Accounting and Auditing Guides that assist preparers interpret and apply existing, generalized GAAP. Second, other industry-specific guidance is inconsistent with generalized GAAP. For example, SFAS No. 51, Financial Reporting by Cable Television Companies, requires that initial hookup revenue (a type of nonrefundable upfront fee) is recorded to the extent of direct selling costs incurred; the remainder is deferred and recorded in income over the estimated average period that subscribers are expected to remain connected to the system. However, generalized guidance indicates this practice is inappropriate unless it is specifically prescribed elsewhere (such as SFAS No. 51).

Therefore, similar activities like upfront fees for gym memberships are not afforded equal treatment. Third, still other industry-specific guidance was created in the absence of a general principle that applies across industries. For instance, while there is no comprehensive revenue recognition standard, SoP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, discusses revenue and cost recognition in areas such as the construction industry.

SAB Topic 13.

Discussion

We generally believe that industry-specific guidance should be eliminated to reduce avoidable complexity, particularly as generalized GAAP is developed. However, we acknowledge that industry-specific guidance has merit when cost-benefit considerations indicate that the enhanced information investors would receive under generalized GAAP is not justified by the direct costs to preparers and the indirect costs to investors to account for activities in that manner. In such cases, the SEC should encourage the FASB to work with the relevant industry participants to identify long-term ways to improve the benefits and mitigate the costs of the general standard. After making these changes, the related industry-specific guidance should be phased out as efficiently as possible. Towards that end, the SEC should encourage the FASB to provide sufficient time to allow companies to adopt generalized GAAP with minimal transition costs.

Similarly, we recognize that industry-specific guidance may be helpful in situations in which: (1) It interprets, rather than contradicts, principles, and (2) the activities in question are legitimately different, which are expected to be rare. But to the extent that such guidance interprets principles (i.e., relates to implementation), we generally believe it should not be considered authoritative GAAP.

Further, to the extent that it applies to

activities that are legitimately different, such guidance should be scoped and applied on the basis of business activities, rather than industries.

We are aware of constituents, such as the AICPA, that have historically issued industry-specific implementation guidance. We generally believe such guidance should not be considered authoritative. Rather, all authoritative guidance should continue to be issued by designated standards-setters, such as the FASB in the U.S., as discussed in chapter 2 of this progress report. If a designated standards-setter issues implementation guidance for activities that are prevalent in particular industries, we believe it should be applicable to all transactions of the type in question, regardless of the industry in which a company operates.

In implementing this proposal, we note that the FASB's codification project can be used to sort existing industry-specific guidance into one of the three categories identified above (consistent with GAAP, inconsistent with GAAP, or there is no comparable GAAP). We believe efforts to reduce existing industry-specific guidance should focus primarily on cases in which it is inconsistent with generalized GAAP. Further, as the FASB develops new generalized guidance in areas like revenue recognition, it should eliminate industry-specific guidance to the maximum extent feasible. Similarly, the SEC should eliminate its industry-specific guidance in related areas, if any.

From an international perspective, we note that IFRS currently contains less industry-specific guidance than GAAP and that such guidance focuses more on the nature of the business activity (e.g., agriculture, insurance contracts, exploration and evaluation of mineral resources). Nonetheless, the SEC should encourage the IASB to be mindful of developed proposal 1.1 as it continues to develop a more comprehensive body of standards. The SEC might also encourage the IASB to limit future industry-specific guidance to activities whose economics are legitimately different from other business activities. Otherwise, we believe specialized accounting for only certain subsets of similar activities will create avoidable complexity.

We acknowledge that the elimination of existing industry-specific guidance may result in more complexity over the short-term to the industries losing special treatment. Nonetheless, we believe it is an acceptable cost for a long-term reduction in avoidable complexity.

II.B. Alternative Accounting Policies

Developed Proposal 1.2: GAAP should be based on a presumption that formally promulgated alternative accounting policies should not exist. The SEC should recommend that any new projects undertaken jointly or separately by the FASB not provide additional optionality, unless, in rare circumstances, it can be justified. Any new projects should include the elimination of existing alternative accounting policies in relevant areas as a specific objective of those projects, unless, in rare circumstances, the optionality can be justified.

Background

Alternative accounting policies refer to optionality in GAAP. The following discussion addresses formally-promulgated options in GAAP, but does not address choices available to preparers at more of a practice or implementation level.

Examples of optionality in GAAP include:

For example, companies are free to choose from among several depreciation methods—straight-line, double-declining balance, etc.

Refer to appendix B for additional examples.

• The indirect versus the direct method of presenting operating cash flows on the statement of cash flows.

• The application of hedge accounting.

We have noted complexities arising from the application of hedge accounting, which allows entities to mitigate reported volatility over the life of the hedge relationship. In this regard, we generally feel that instead of assessing hedge effectiveness to determine whether companies qualify for this alternative accounting treatment, a better policy would be to simply record the ineffective portion of a hedge in earnings (i.e., a proportionate approach versus an all-or-nothing approach). We are also aware of the FASB's derivatives project in this area and are generally supportive of its progress.

• The option to measure certain financial assets and liabilities at fair value.

• The immediate or delayed recognition of gains/losses associated with defined benefit pension and other post-retirement employee benefit plans.

• The successful efforts or full cost accounting method followed by oil and gas producers.

Alternative accounting policies arise for a number of reasons. These reasons include circumstances in which the pros and cons of competing policies may be balanced and thus do not result in a single, clearly preferable approach. Other causes encompass political pressure that results in standards-setters providing for a preferred and an alternative accounting method, high administrative costs of the preferred alternative to preparers (e.g., cost-benefit considerations), and a portrayal of differences in management intent.

Alternative accounting policies contribute to avoidable complexity by making financial reports less comparable. This is evident across companies when identical activities are accounted for differently. Such alternatives may permit accounting that is less reflective of economic substance to the extent that they are based on political pressure, and facilitate differences in accounting policies selected by preparers to achieve the most favorable treatment. The unnecessary proliferation of accounting literature to codify these alternatives also adds to avoidable complexity.

On the other hand, alternative accounting policies may alleviate complexity by allowing preparers to determine the best accounting for particular entities based on cost and economic substance, to the extent that more than one accounting policy is conceptually sound. In addition, certain alternative policies may be developed more quickly than a final “perfect” standard to minimize the effect of other unacceptable practices. In other words, they may function as a short-term fix on the road to ideal accounting.

Management Intent

Some alternative accounting policies are based on management intent.

Management intent is a present assertion about management's plans for future courses of action.

For example, SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, allows management to classify certain debt instruments as either a held-to-maturity, an available-for-sale, or a trading security based on the company's intent and ability with respect to the holding period of its investment. The financial statement treatment differs for all three categories.

The definition of management intent and certain other concepts in the discussion of alternative accounting policies are adapted from a FASB Special Report: Future Events: A Conceptual Study of Their Significance for Recognition and Measurement (1994).

We have separately considered the merits of alternative accounting policies arising from differences in management intent. Opponents of the use of management intent as a basis for accounting believe that because intentions are subjective, it is difficult to use intent as a basis for accounting. Opponents also believe that intent does not change the economics of a transaction and thus, would not be a representationally faithful basis of accounting.

Proponents assert that the economics of a transaction do, in fact, change based on the nature of the activity, which is driven by management intent. Proponents also note that, while management intent is subjective and could change, this characteristic is no different from a management estimate, which is common in financial reporting. Proponents further argue that financial reporting that ignores management intent results in irrelevant information for investors, for instance, reporting the fair value of a held-to-maturity security that will not be settled for 30 years.

Due to the varying levels of management intent throughout GAAP and the merits of the arguments both for and against its use, we have determined that accounting based on management intent is too dependent on facts and circumstances to feasibly address within our timeframe.

Discussion

Setting aside any consideration of management intent, we believe alternative accounting policies should be eliminated, except in limited circumstances in which they may have merit. Possible justifications for retaining alternative accounting policies include situations in which: (1) Multiple accounting alternatives exist that are consistent with the conceptual framework, and none are determined to provide significantly better information to investors than others, and (2) an alternative or interim treatment can be developed more quickly than a final “perfect” standard to minimize the effect of other unacceptable practices.

If one or both of the justifications above apply, we believe that the provision of alternative accounting principles should be coupled with a long-term plan by the FASB to eliminate the alternative(s) through the use of sunset provisions and that the effect of applying the alternative policy not selected by preparers should be clearly and succinctly communicated to investors (e.g., through footnote disclosure).

Further, as new guidance is issued, including that which is issued through the convergence process, the SEC should eliminate its alternative accounting policies in related areas, if any.

From an international perspective, we note that IFRS currently permits numerous alternative accounting policies. While we acknowledge the IASB's efforts in reducing some of these alternative treatments, we nonetheless believe that the SEC should encourage the IASB, like the FASB, to be mindful of this proposal, and seek to eliminate alternatives as part of its standards-setting projects.

III. Bright Lines

Conceptual Approach 1.A: We are considering recommending expanded use of the following, in place of the current use of bright lines, to better reflect the economic substance of an activity:

• Proportionate recognition—We use the term “proportionate recognition” in contrast to the current all-or-nothing recognition approach in GAAP. 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 $40

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.

Calculated as (4 year lease/10 year useful life) x $100 machine value. The example is only intended to be illustrative and is not prescriptive. For instance, the basis of proportionate recognition may be an asset's estimated useful life, future cash flows, or the share of a company's liabilities in a structured investment vehicle. We are planning additional deliberations in this regard.

• Additional disclosure—We recognize that proportionate recognition is not universally applicable. In those cases, enhanced disclosure may be more appropriate. We have yet to define the possible scope of proportionate recognition and/or enhanced disclosure, but it may extend to areas such as leases, consolidation policy and off-balance sheet activity.

• Rules-of-thumb or presumptions, both coupled with additional considerations—We use rule-of-thumb and presumption to describe a method by which an accounting conclusion may be initially favored, subject to the consideration of additional factors. These are less stringent than bright lines, and may be appropriate where proportionate recognition may not apply.

Conceptual Approach 1.B: Further, we are considering a recommendation related to the education of students, as well as to the continuing education of investors, preparers, and auditors. The recommendation would encourage understanding of the economic substance and business purposes of transactions, in contrast to mechanical compliance with rules without sufficient context.

Background

Bright lines refer to two main areas: quantified thresholds and pass/fail tests.

Refer to appendix B for additional examples other than those discussed in this section.

Quantified thresholds include hard-and-fast cutoffs, as well as rules-of-thumb or presumptions—both coupled with additional considerations. 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,

where a mere 1% difference in the results of the quantitative tests leads to very different accounting.

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.

With respect to rules-of-thumb, consolidation guidance

generally requires at least a 10% equity investment in a company (i.e., the equity investment expressed as a percentage of total assets) to demonstrate that the investee company is not considered a variable interest entity (VIE). The determination as to whether an entity is a VIE drives who, if anyone, ultimately consolidates the VIE in its financial statements. However, entities with investments above and below the 10% level can still be considered VIEs, depending on the particular facts and circumstances. That is, the 10% rule-of-thumb is not determinative in its own right.

FASB Interpretation No. (FIN) 46 (revised December 2003), Consolidation of Variable Interest Entities (FIN 46R).

Similarly, the business combination literature

contains an example of a presumption coupled with additional considerations. There are situations in which selling shareholders of a target company are hired as employees by the purchaser. For instance, 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.

Emerging Issues Task Force (EITF) 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination. We note 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.

As indicated above, 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 reasons 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 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

We are still in the process of debating when, if at all, bright lines are justified in accounting literature. We note that even if the FASB limits the issuance of bright lines, other parties might continue to create similar non-authoritative guidance. As such, recommendations to limit bright lines would require a cultural shift towards acceptance of more judgment. Accordingly, any recommendations in the context of bright lines will incorporate our consideration of a professional judgment framework, as discussed in chapter 3, and our consideration of interpretive implementation guidance and a new design approach to accounting standards, as discussed in chapter 2.

IV. Mixed Attribute Model and the Appropriate Use of Fair Value

Conceptual Approach 1.C: Measurement framework—While we may not have time to fully address when fair value is the appropriate measurement attribute, we understand that the FASB's joint conceptual framework project includes a measurement phase. We intend to study this project further and are considering a recommendation for the SEC to endorse that, as part of this project, the FASB develop a decision framework to provide a systematic approach for consistently determining the most appropriate measurement attribute for similar activities or assets/liabilities based on consideration of the trade off between relevance and reliability, and the various constituents involved in the financial reporting process.

Conceptual Approach 1.D: Judicious Use of Fair Value—Due to implementation complexities, as noted below, we are considering whether the SEC should request that the FASB be judicious about issuing new standards and interpretations that require the expanded use of fair value in areas where it is not already required, until completion of a measurement framework. Over the long-term, this framework would be used to determine measurement attributes systematically.

We will also consider whether improvements related to certain existing, particularly-complex, standards that incorporate fair value, such as SFAS Nos. 133

and 140,

are warranted in the near-term.

We recognize that the joint FASB/IASB conceptual framework project, including the measurement phase, is a significant undertaking that most likely will not be completed in the near-term. Consequently, we may explore whether a recommendation is warranted for a formal SEC study regarding when fair value is appropriate in financial reporting. The study's report could then be incorporated in future standards-setting activity.

Accounting for Derivatives and Hedging Activities.

Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

Conceptual Approach 1.E: Groupings in Financial Statement Presentation—We believe that a more consistently aggregated presentation of financial statements would alleviate some of the confusion and concerns regarding the use of fair value. Such presentation should result in the grouping of amounts and line items by nature of activity and measurement attribute within and across financial statements. We believe such a grouping would be more understandable to investors, particularly as it would more clearly delineate the nature of changes in income (e.g., fair value volatility, changes in estimate, and business activity). This presentation might also help investors assess the degree to which management controls each source of income.

As part of the financial statement presentation project, the FASB has tentatively decided to segregate the financial statements into business (further divided into operating and investing) and financing activities. The FASB has also tentatively decided to require a reconciliation of the statement of cash flows to the statement of comprehensive income. This reconciliation would disaggregate changes in assets and liabilities based

on cash, accruals, and changes in fair value, among others.

We intend to study this project further and consider whether it would address the our leanings in this area and sufficiently facilitate investors' understanding of fair value.

Conceptual Approach 1.F: Additional Disclosure—We have identified potential areas for additional disclosure to more effectively signal to investors the level of uncertainty associated with fair value measurements in financial statements.

Specifically, we note that in some 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. Potential areas to be considered for additional disclosure may include:

We acknowledge uncertainty also exists in other measurement attributes, such as historic cost, which may warrant similar disclosure.

• The valuation model.

• Statistical confidence intervals associated with certain valuation models.

• Key assumptions, including projections.

• Sensitivity analyses depending on the selection of key assumptions.

• The entity's position versus that of the entire market.

Conceptual Approach 1.G: Disclosure Framework—We seek to balance additional disclosure requirements, including, if any, those under conceptual approach 1.F, with: (1) The perception that amounts recognized in financial statements are generally subject to more precise calculations by preparers and higher degrees of scrutiny by investors compared to merely disclosing such amounts in the footnotes, and (2) concerns regarding disclosure redundancies. To minimize the effect of diminishing returns on potential new disclosure improvements identified during the course of our efforts and future standards-setting activity, we are considering recommending: (1) That the SEC request the FASB to develop a disclosure framework that integrates existing disclosure requirements into a cohesive whole (e.g., eliminate redundant disclosures and provide a single source of disclosure guidance across all accounting standards), (2) improvement to the piecemeal approach to establishing disclosures (i.e., standard-by-standard), and (3) that the SEC develop a process to regularly evaluate and, as appropriate, update its disclosure requirements as new FASB standards are issued.

Background

As previously noted, the mixed attribute model is one in which the carrying amounts of some assets and liabilities are measured based on historical cost, others at lower of cost or market, and still others at fair value. This complexity is compounded by requirements to record some adjustments to carrying amounts in earnings and others in comprehensive income.

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.

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 avoidable 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, we assume 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: (1) Are averse to market-driven volatility, and as a result, (2) incorporate unfavorable assumptions or discounts within their assessments of a company's financial performance. 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.

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 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. Fair value might also 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 discussed in section II.B of this chapter, 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

We acknowledge the view that a complete transition to fair value would alleviate avoidable complexity resulting from the mixed attribute model. However, we also recognize that expanded use of fair value would increase avoidable complexity, as discussed above, unless numerous implementation questions related to relevance and reliability are addressed, which extend beyond the scope of our work.

In light of our limited duration, we recognize that we may not independently develop a comprehensive measurement framework, but we plan to provide input to the FASB's projects in this area (see conceptual approach 1.C on the measurement framework and conceptual approach 1.E on groupings in financial statement presentation). As a result, we believe that recommendations requiring a systematic measurement framework and better communication of measurement attributes would more feasibly reduce avoidable complexity resulting from the mixed attribute model. Such communication encompasses footnote disclosure of each measurement attribute's characteristics (e.g., uncertainty associated with fair value), as well as a more systematic presentation of distinct measurement attributes on the face of the primary financial statements.

V. Future Considerations

As noted in the introduction to this chapter, exceptions to general principles create complexity because they deviate from established standards that are applicable to most companies. Our developed proposals with respect to industry-specific guidance and alternative accounting policies address two forms of this diversity. We intend to deliberate two remaining forms of such diversity during the course of our work later in 2008.

Scope Exceptions in GAAP Other Than Industry-Specific Guidance

noted previously, scope exceptions other than industry-specific guidance represent departures from a principle. They contribute to avoidable complexity because they result in different accounting for similar activities, require detailed analyses to determine whether or not they apply in particular situations, and increase the volume of accounting literature. On the other hand, the value of scope exceptions will be considered in light of cost-benefit considerations, practical approaches to issuing guidance in the near-term before more principled standards can be developed, and the magnitude of change that would result from eliminating or reducing them.

We have limited our focus to scope exceptions, while acknowledging there are other types of exceptions in GAAP. This limited approach was considered appropriate in light of our short duration.

Examples of scope exceptions include: (1) A contract that has the characteristics of a guarantee under FIN 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, but is treated as contingent rent under SFAS No. 13, Accounting for Leases; (2) the business scope exception to the applicability of FIN 46R, Consolidation of Variable Interest Entities, subject to certain criteria; and (3) the application of SFAS No. 157, Fair Value Measurements, to share-based payment transactions.

Competing Models

Competing models are distinguished here from alternative accounting policies. Alternative accounting policies, as explained above, 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 include different methods of asset impairment testing such as inventory, goodwill, and deferred tax assets, etc.

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.

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.

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, the value of competing models will be considered in light of cost-benefit considerations, practical approaches to issuing guidance in the near-term before more principled standards can be developed, and the

magnitude of change that would result from eliminating or reducing them. We will also explore the relationship between competing models and the FASB's conceptual framework.

Chapter 2: Standards-Setting Process

I. Introduction

A robust standards-setting process is the foundation of an efficient system of financial accounting and reporting, on which capital providers may rely to make investment decisions. Although the U.S. approach to financial reporting has been quite effective in achieving that overarching objective, GAAP has evolved over many years to a point whereby some of the basic principles are obfuscated by detailed interpretive rules, as well as various exceptions and alternatives, which reduce the usefulness of the resulting financial reporting. Historically, interpretative rules on how to implement GAAP (interpretive implementation guidance) have proliferated from a variety of sources and, intentionally or not, have become perceived as additional GAAP. This increases the complexity of the financial reporting system and reduces its transparency for investors, especially when questions exist about the authoritative nature of such guidance or conflicts exist between interpretations.

This chapter advances developed proposals, conceptual approaches, and matters for future consideration intended to alleviate some of these concerns. Specifically, after examining the U.S. standards-setting process, we propose changes in the following areas:

• Increased investor representation in standards-setting.

• Enhancements in governance and oversight.

• Improvements in the process of setting new standards.

• Narrowing the sources of interpretive implementation guidance.

In general, we believe the design of the U.S. financial reporting system and the role played by each participant are appropriate. However, improvements to the existing standards-setting process, including the process of issuing interpretive implementation guidance, may significantly influence behaviors and thereby help financial reporting better serve the needs of investors.

Some of our proposals may be partially or substantially addressed by actions recently taken or in the process of being taken by the FAF, the FASB, and the SEC, which we reference where applicable. Other aspects of our proposals are already in place or occur informally in practice, but may not be fully effective or well understood. Nevertheless, our proposals are designed to increase the effectiveness and transparency of these processes.

II. Investor Representation

Investor representation in standards-setting is critical to maintaining an effective system of financial reporting, yet the intricacy of certain accounting matters has sometimes made it difficult to attract meaningful investor participation. Our proposals are intended to underscore the pre-eminence of investor perspectives in developing and administering a well-designed and effective system of financial reporting. The current standards-setting process attempts to balance the views of different stakeholders. However, the financial reporting system would best be served by recognizing that the perspectives of investors should be pre-eminent when competing interests cannot be aligned, because all stakeholders benefit from a system that allocates capital more efficiently.

We acknowledge the FASB's significant recent efforts to increase investor participation in standards-setting. Specifically, the FASB leveraged a number of existing advisory groups and created additional advisory groups to increase investor involvement. Our proposal below is intended to provide the FASB with more focused, efficient, and timely feedback from investors, both large and small.

Developed Proposal 2.1: Additional investor representation on standards-setting bodies is central to improving financial reporting. Only if investor perspectives are properly considered by all parties will the output of the financial reporting process meet the needs of those for whom it is primarily intended to serve. Therefore, the perspectives of investors should have pre-eminence. To achieve that pre-eminence in standards-setting, the SEC should encourage the following improvements:

• Add investors to the Financial Accounting Foundation (FAF) to give more weight to the views of different types of investors, both large and small.

FAF: Our proposal complements the FAF's recently proposed governance reforms.

The FAF proposes to expand the sources of FAF Trustee nominations, change terms of service, and create flexibility in the size of the FAF itself. We support these proposals, particularly the decision to reduce reliance on constituent-based sponsoring organizations to put forward FAF Trustees. However, we believe additional investor representation on the FAF should also be emphasized. Such representation should strive to consider differing perspectives in the investing community.

FAF, Request for Comments on Proposed Changes to Oversight, Structure and Operations of the FAF, FASB and GASB (December 18, 2007). Our deliberation of the FAF request for comments focused on the FAF and FASB proposals, as the Governmental Accounting Standards Board (GASB) is outside of our scope.

FASB and FASB Staff: Increasing direct investor involvement on the Board would benefit the FASB by bringing investor perspectives to the forefront of standards-setting and the process of issuing interpretive implementation guidance. We propose that the composition of the Board include no fewer than one, and perhaps more than one, experienced investor who regularly uses third-party financial statements to make investment decisions.

Our proposal assumes that the FAF will implement its proposed reduction in the size of the FASB from seven to five members. If this reduction is made, we believe the composition of the Board should be reconsidered to require that a preparer, an auditor, and at least one experienced investor who regularly uses third-party financial statements to make investment decisions are all represented. In our view, although academic representation on the Board should be actively sought, it should not be mandated. If the FASB consists of five members, our suggested approach would increase the influence of investors. While we recognize that workload capacity concerns may be created by a reduction in the size of the Board, we believe that these concerns may be mitigated by more delegation of responsibilities to senior staff members and a possible increase in the size of the FASB staff. On the other hand, if the FAF does not reduce the FASB's size, at least two investors should be required on the Board. The remaining at-large Board members should be selected from the most qualified individuals who possess a breadth of experiences that will ensure that the perspectives of investors are carefully considered.

There may be opportunities to increase investor representation on the FASB staff as well. The FASB has a few staff with professional investing experience. The FASB also has had a fellowship program for many years, but

fellows usually come from the auditor and preparer communities. The FASB has approached investor groups about the possibility of sponsoring fellows, but, thus far, has had limited success. Investors should promote the fellowship positions and encourage qualified applicants to join the FASB staff to help enhance investor input in standards-setting.

In addition, the FAF should consider staffing alternatives that make greater use of part-time Board members or part-time senior staff for particular projects or purposes. However, we recognize that conflict of interest and independence issues would have to be resolved.

III. FAF and FASB Governance

The FAF Board of Trustees is responsible for the oversight, funding, and appointment of Board members of the FASB and the GASB. While the FAF Board of Trustees does not direct the standards-setting activities of the FASB, it does have a responsibility to periodically review the FASB's structure and governance to assess its effectiveness and efficiency. The FAF has always maintained oversight of the FASB as one of its main priorities. Our proposal below is designed to promote more active FAF oversight of the FASB—in order to shorten the time taken to develop standards, as well as to improve their quality:

Developed Proposal 2.2: The SEC should assist the FAF with enhancing its governance of the FASB, as follows:

• By encouraging the FAF to develop performance metrics to assess the FASB's adherence to the goals in its mission statement, objectives, and precepts and to improve its efficiency.

• By supporting the FAF's changes outlined in its “Request for Comments on Proposed Changes to Oversight, Structure and Operations of the FAF, FASB and GASB,” with minor modifications regarding composition of the FAF and the FASB, as proposed in section II of this chapter, and agenda-setting, as proposed in section IV of this chapter.

• By encouraging the FAF to amend the FASB's mission statement, stated objectives, and precepts to emphasize that an additional goal should be to minimize avoidable complexity.

Performance Metrics: The FAF should develop performance metrics to assess the FASB's adherence to the goals in its mission statement, objectives, and precepts. These metrics should track the timeliness and effectiveness of the FASB's standards-setting process. Such metrics would not have a detrimental impact on the FASB's independence. Rather, they would improve accountability in standards-setting.

Proposed FAF Governance Changes: We support the FAF's governance proposals as outlined below, with minor modifications regarding composition of the FAF and the FASB, as proposed in section II of this chapter, and agenda-setting, as proposed in section IV of this chapter:

FAF Oversight: The FAF proposes to increase its active oversight of the FASB. We support this proposal, but we note that the FAF has not described how it intends to implement it. Many of the developed proposals and conceptual approaches in this chapter provide input regarding how and in what areas to strengthen such oversight.

FASB Voting: The FAF proposal maintains the FASB's current simple majority voting requirement. We support simple majority rather than supermajority voting to promote the timeliness of standards-setting.

Mission and Objectives: The FASB's mission statement, objectives, and precepts acknowledge that efficient capital markets rely on credible, concise, and understandable financial information. They also recognize the importance of the following:

• Improving the usefulness of financial information by focusing on relevance, reliability, comparability, and consistency.

• Keeping standards current.

• Considering promptly significant areas of deficiency that need improvement.

• Promoting international convergence.

• Improving the understanding of the nature and purpose of information in financial reports.

• Being objective in decision-making and promoting neutrality of information.

• Weighing carefully the views of constituents.

• Satisfying the cost-benefit constraint.

• Minimizing disruption by providing reasonable effective dates and transition provisions.

• Reviewing the effects of past decisions in a timely fashion to interpret, amend, or replace standards, when necessary.

• Following an open, orderly process for standards-setting.

We believe minimizing avoidable complexity should be added to this list. Although we do not believe the FASB sets out to issue complex standards, amending the mission statement, stated objectives, and precepts may promote more explicit consideration of less complex accounting alternatives during standards-setting.

IV. Standards-Setting Process Improvements

The U.S. standards-setting process requires significant due process. The FASB's activities are open to public participation and observation, and the FASB actively solicits the views of its various constituents on accounting issues. We believe the FASB's approach to obtaining significant input through its open due process is fitting, although there is a difficult trade-off between a transparent due process and expediency.

We believe the FASB's processes need improvement. Critics argue that it may take too long for the issuance of new accounting standards or interpretive implementation guidance in response to changes in business practices or the economic environment. They point to projects that have been on the FASB's agenda for years to illustrate that fundamental issues are routinely given low priorities. They further argue that new standards are not always consistent and may be based on several different, or even conflicting, principles. This may be due to a number of reasons, including the lack of a completed conceptual framework, competing priorities placed on the Board, or the evolutionary nature of standards-setting in the U.S.

Due to its practice of being continually open to constituent input, the FASB may receive conflicting advice regarding its agenda. Projects are frequently added to the agenda in response to requests from constituents, but projects not being actively considered are seldom removed. The FASB may be working on projects that could be better addressed in other ways, or not at all. In either case, such projects divert resources from other important agenda items. Further, even though the FASB has a transparent due process, new standards are often met with requests for interpretive implementation guidance, implementation deferral, or amendment.

Our proposal below is designed to further enhance the U.S. standards-setting process and its timeliness.

Developed Proposal 2.3: The SEC should encourage the FASB to further improve its standards-setting process and timeliness, as follows:

• Refine procedures for issuing new standards by: (1) Implementing investor

pre-reviews designed to assess perceived benefits to investors, (2) enhancing cost-benefit analyses, and (3) requiring improved field visits and field tests.

• Improve processes to keep existing standards current and to reflect changes in the business environment by conducting periodic assessments of existing standards.

Some of our proposed process improvements call for formalizing or improving existing processes, or implementing new processes to improve standards-setting outputs. Our proposed Agenda Advisory Group would help the FASB, the SEC, and other participants in the financial reporting community focus efforts on the most meaningful activities and centralize constituent input to improve the timeliness of standards-setting.

Agenda Advisory Group: The first step in standards-setting is agenda-setting. The FASB receives many requests to act on various topics from many constituents, including the SEC. The FASB also needs to fulfill its obligations under the Memo of Understanding with the IASB regarding international convergence. Requests for interpretations or amendments divert attention from other critical agenda items. FASB agenda decisions often add rather than delete projects. Further, given the volume of activity on the FASB agenda, Board and staff prioritization conclusions are not always clear to constituents. What may result is that projects being addressed may not be responsive to widely acknowledged needs, or projects may not have sufficiently-defined scopes to address these needs in a timely fashion. The FASB has a number of existing advisory groups and committees that it consults about issues that may affect its agenda and project priorities; however, we believe there needs to be increased accountability to the FAF on agenda-setting and project priorities.

An Agenda Advisory Group that includes strong representation from investors, the SEC, the FASB, and the PCAOB, as well as other interested parties such as preparers and auditors, should be created to provide advice on agenda-setting. By identifying emerging issues and building consensus about which group is best positioned to deal with them (e.g., the FASB, the EITF, or the SEC) and in what form, the Agenda Advisory Group would give immediate input about how best to prioritize near-term versus long-term priorities. The main goals of such a group would be to:

• Help standards-setting become more nimble.

• Assist the FASB is setting an achievable, strategic agenda, rather than one that includes projects proposed for many years with little progress.

• Recommend when it is appropriate for the SEC or other parties to issue interpretive implementation guidance related to emerging issues and issues observed by the SEC in its registrant reviews.

• Help the FASB maintain the usefulness of its authoritative guidance by recommending areas that need to be kept current.

• Shield the FASB from influence by any single group of constituents, thereby protecting its independence.

• Inject accountability into agenda-setting for all involved parties.

Our proposal complements the FAF's proposed changes to the FASB's agenda-setting process in which the FAF would give the FASB Chairman control over the FASB's agenda. We believe instilling more decision-making authority in the FASB Chairman, combined with a requirement to consult with the proposed Agenda Advisory Group, would be a positive step toward increasing the FASB's efficiency.

In creating such an Agenda Advisory Group, the SEC and the FASB should consider ways to implement the following objectives:

• Timeliness. The Agenda Advisory Group should be convened both on a regular schedule and on short notice telephonically to deal with urgent matters, as necessary.

• Accountability. The Agenda Advisory Group should vote on certain aspects of the standards-setting agenda and provide that information in an advisory capacity to the FASB Chairman, who would then make the final agenda decision. Part of the rationale for calling a vote would be to increase accountability of the FASB Chairman to the FAF regarding agenda-setting effectiveness.

• Active involvement of key groups of investors. Key investor groups should be actively involved in agenda-setting to maintain an appropriate focus on investor needs.

• Involvement of the SEC. Due to the SEC's oversight responsibility for standards-setting, one or more senior representatives from the SEC Office of the Chief Accountant (OCA) should be on the Agenda Advisory Group, as the SEC typically identifies practice issues before the FASB does. In addition, active involvement by the SEC will allow coordination of how and by whom guidance should be issued, thereby reducing the impetus for the SEC to issue interpretive implementation guidance separately from the codified version of GAAP (see section VI of this chapter).

• Involvement of the FASB. All Board members should be invited as official observers.

• Involvement of the PCAOB. A senior representative from the PCAOB should be invited as an official observer, as actions taken by the PCAOB significantly impact behavior of participants in the U.S. financial reporting community.

• Involvement of others. Constituents otherwise not represented should be able to submit agenda requests and track agenda decisions, similar to the way in which the EITF functions.

Formulating and Proposing New Standards: The FASB has an elaborate process for formulating and proposing new standards. This process is designed to ensure that proposed standards properly address significant issues, are consistent with business practices and economics, and have benefits that justify accounting changes. It involves staff preparation of a draft proposal, publication of the proposal with an opportunity for public comment, and approval of the final standard. Throughout the process, the FASB consults with and receives input from a diverse group of constituents. This process is time consuming, often taking many years, and could be made more efficient. The Board's outreach to certain constituents sometimes seeks advice only on detailed issues rather than the scope of projects and broad matters. Our proposal would increase the efficiency and effectiveness of standards-setting by obtaining more focused inputs at an earlier stage through investor pre-reviews, enhanced cost-benefit analyses, and more field visits and field testing.

Investor Pre-Reviews: Although the FASB regularly consults with a number of standing investor advisory groups, we believe that there may be opportunities to both increase and more effectively manage investor involvement, so that interested parties know when and how to engage the FASB and its staff to assist in standards-setting. Specifically, the FASB should implement a scalable investor pre-review to assess perceived investor benefits prior to exposing new standards for public comment. The FASB should consider the following attributes when designing such a pre-review:

• Seek detailed comments from a diverse panel of investors (e.g., buy-side analysts, sell-side analysts, and rating agencies), all of whom should have strong interests in the outcome.

• Ask investors to consider the accounting guidance through the eyes of a serious retail investor to determine whether the new information provided would be decision-useful (whether it will provide better information than what is currently available). This should entail an evaluation of the costs and benefits of updating data analysis models with the new or improved information, as necessary.

• Revisit or even discontinue standards-setting projects based on the feedback received.

Cost-Benefit Analyses: The FASB evaluates whether the benefits of a proposed standard justify its costs prior to exposing it for public comment. However, participants in standards-setting have long acknowledged that reliable, quantitative cost-benefit calculations are seldom feasible, in large part because of the lack of available information on the costs and the difficulty in quantifying the benefits. Further, the magnitude of the benefits and costs is difficult to assess prior to actual implementation of the standard. As a result, cost-benefit considerations are often based on anecdotal evidence and do not always include useful input from preparers, auditors, investors, and regulators. Cost-benefit analyses should be a more rigorous, essential part of standards-setting and should be given more weight than they are today.

The FASB is currently considering new initiatives to improve its cost-benefit analyses. We support these efforts and, to complement them, the FASB should consider the following enhancements to its cost-benefit procedures:

• Select preparers, auditors, investors, and regulators to be involved based on their interest in the standard or interpretive implementation guidance being developed. Such participants should be involved in the process of assessing costs and benefits, as well as performing field visits and field testing, to the extent feasible.

• Expose the entire cost-benefit analysis for public comment (rather than a summary or abstract), thereby enhancing the ability of interested constituents to comment on the conclusions reached and the basis for these conclusions.

• Attempt to better quantify the costs (in addition to providing qualitative assessments). If there is concern about the accuracy or reliability of the data, frame these concerns in the analysis rather than omitting the data. The FASB should request a cost estimate and underlying methodology from constituents who claim that costs are excessive.

• Use information collected in the investor pre-review to supplement the assessment of the benefits.

• Refrain from discussing costs and benefits on a net basis, as this sometimes creates opacity around the data underlying such conclusions. The analyses of costs and benefits should be prepared separately, with an indication of how the Board weighed the evidence in its conclusion.

• Add auxiliary information to put the accounting standard or interpretive implementation guidance in context (e.g., include an expectation of the number of companies to be impacted by the standard, their overall market capitalization, or other metrics).

• Improve the documentation of the cost-benefit conclusions in new standards so that they may be referred to over time.

• Consider hiring an economist to assist in preparing and reviewing cost-benefit analyses.

Field Visits and Field Testing: Throughout the deliberation process, the FASB meets with a number of interested constituents regarding proposed standards (referred to as “field visits”). Once the proposed standard is exposed for public comment, the FASB at its discretion may conduct field tests, in which the implementation of a proposed standard is beta tested so that issues may be identified and resolved prior to final issuance of the new standard. However, as a practical matter, and because of resource constraints, robust field testing has not been part of the process for setting many recent standards. As a result, new standards are often met with requests for interpretive implementation guidance, implementation deferral, or amendment.

Whenever possible, scalable field visits and field tests should be a required part of standards-setting for all significant new standards to identify and resolve as many conceptual and implementation issues as practicable prior to issuance. These procedures may also identify less costly alternative accounting treatments. The rigor required for these procedures should be scaled based on the difficulty and length of time required to implement and the magnitude of the impact of the standard or interpretive implementation guidance. In addition, whenever possible, field visits and field testing should occur contemporaneously, to improve the focus and efficiency of receiving constituent input. Although robust field testing and field visits require resources and time, combining these efforts will make efficient use of the Board's and its staff's time. Moreover, by researching implementation questions prior to issuing a new standard, the FASB would reduce the amount of time spent considering possible interpretive implementation guidance, implementation deferral, or amendment.

The FASB also should leverage work already being done by preparers, auditors, and investors to assess the costs, benefits, operationality, and auditability of proposed standards. Requesting assistance from preparers, auditors, and investors, either directly or through task forces and resource groups (perhaps on more of a rotational basis than is done in practice today), would bring additional subject matter expertise and recent business experience to each field visit and field test.

Post-Adoption Reviews of New Standards: We acknowledge that it is difficult to identify and address all possible implementation issues in a new standard prior to it being issued and adopted. Issues and questions are often identified during the initial implementation phase as preparers and auditors begin to apply a new standard in practice. Preparers, auditors, and others often monitor and take measures to reduce diversity in practice when implementing new standards by conferring amongst themselves and issuing non-authoritative interpretive implementation guidance. During this initial period, requests are often made of the FASB and the SEC to provide interpretive implementation guidance for new standards.

In the current financial reporting environment, preparers and auditors are sometimes viewed as being penalized for implementing their understanding of new accounting standards immediately after adoption. This is because any ambiguity or substantial gaps identified in the implementation period may lead the regulators to issue interpretive implementation guidance that differs from conclusions originally reached by the preparers and auditors.

The FASB should improve existing processes to consistently ensure timely consideration of implementation issues for new accounting standards. The goal of post-adoption reviews of new standards would be to determine if the new standard is accomplishing its intended purpose or whether it has unintended consequences that need to be resolved. The FASB currently does address questions that arise after new

standards are issued—it regularly receives input from various constituents and periodically revisits some standards. However, the process of completing post-adoption reviews should be formalized in policy, be more systematic, involve input from a broader range of constituents, and be monitored using relevant performance metrics.

Specifically, the FASB should perform a post-adoption review for every significant new standard. The review should be completed no more than one to two years after the effective date of the standard, with completion sooner if the scale of the new standard is narrow or a large number of implementation questions arise. At the end of the review period, the FASB should reach a formal conclusion on each new standard to determine if interpretive implementation guidance would serve the needs of investors by reducing diversity in practice or otherwise improving the application of the standard (e.g., by resolving ambiguities in the wording or filling-in unintended gaps in the standard).

We believe that, when necessary, interpretive implementation guidance for new standards is best given by the FASB using:

• A transparent due process with public comment.

• Appropriate transition guidance and required disclosures that will provide investors with useful information regarding possible changes in accounting.

• The codified version of GAAP.

Understandably, some interpretive implementation guidance may be of such an urgent nature that a transparent due process would not be responsive to the needs of market participants. Therefore, we envision that the SEC or other parties, through representation on the Agenda Advisory Group, could assist by agreeing to issue interpretive implementation guidance in such situations (see section VI of this chapter).

Under our proposal, it is not contemplated that preparers would have the flexibility to implement new standards at different times nor have the ability to adopt early or late. Following the recent policy decision by the FASB precluding early adoption of new standards, our proposal contemplates transition guidance for a new standard with a stated, required implementation date. Similarly, this proposal is not a safe harbor. Violations of GAAP will continue to be dealt with by the SEC through the review, comment, restatement, and enforcement processes. However, the SEC should give appropriate consideration to situations in which there were ambiguities or gaps in the new standards that could be subject to more than one reasonable interpretation. For example, it may be inappropriate for the SEC to bring an SEC enforcement proceeding based on a new accounting standard if, after careful analysis and due diligence made in good faith, the registrant took a reasonable and supportable view of that standard, which was subsequently changed by formal amendment or published interpretation.

Periodic Assessment of Existing Standards: After a new accounting standard has been in place for a reasonable period, more data is likely to be available to evaluate its benefits and costs. Further, over time economic conditions and business practices may change, such that older accounting standards may lose their relevance and effectiveness. Some participants in the financial reporting community have commented that numerous accounting standards or models need immediate reevaluation. In today's economic environment, the accounting for securitizations and structured products with off-balance sheet risk are cited as needing reevaluation.

The accounting for financial guarantees, convertible debt, and derivatives and hedging activities are also frequently cited areas for improvement.

SEC Staff, Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers (June 2005).

The process by which the FASB receives, evaluates, and addresses concerns about the usefulness of standards in a timely fashion is critical to the proper functioning of the U.S. capital markets. The FASB should improve and formalize this process to ensure that standards continue to be useful in the current economic and business environment. This should be done by formalizing the process of periodically requesting feedback from investors, preparers, auditors, and regulators regarding what areas of GAAP need reevaluation because they create practice problems or are unnecessarily complex. In addition, to identify other specific areas of GAAP in need of review, the FASB should consider the following:

• Restatement activity.

• Emerging issues and the amount of interpretive implementation guidance issued on particular standards.

• Changes in business practices and the economy.

• New cost-benefit information as it becomes available.

Further, when evaluating the feedback received from constituents and the results of its own research, the FASB should seek advice from the Agenda Advisory Group to help prioritize its agenda.

V. Interpretive Implementation Guidance

We believe that there are too many sources of interpretive implementation guidance. Historically, this guidance proliferated from a variety of sources, which intentionally or not, has been viewed as additional GAAP. In other words, interpretive implementation guidance that is not formally authoritative often is erroneously perceived by participants in the financial reporting and legal communities to be quasi-authoritative. The key risks associated with a proliferation of interpretive implementation guidance are that: (1) The appropriate rule may not be identified and considered, and (2) it may conflict with authoritative guidance, as well as with other non-authoritative guidance, causing uncertainty in application and legal risk.

Over the past few years, the FASB and the SEC have taken steps intended to reduce the proliferation of interpretive implementation guidance from different authoritative bodies. For example, the SEC recognized the standards of the FASB as generally-accepted, and the FASB limited the ability of other bodies to create authoritative guidance without FASB ratification. Nevertheless, the SEC staff continues to be a source of interpretive implementation guidance in its own right, through such vehicles as comment letters, staff speeches, SABs, and other forms of exchange that, although typically non-authoritative, are perceived as quasi-authoritative. Similarly, actions taken by the FASB and the SEC have not sufficiently curbed the creation of other non-authoritative interpretive implementation guidance, such as that from audit firms, preparer and industry groups, academia, the Center for Audit Quality (CAQ), and other regulators.

Our proposal below, which should be read in conjunction with conceptual approach 2.A, is designed to recognize recent accomplishments in this area, clarify what guidance is authoritative and non-authoritative, and further influence the behaviors that have led to the desire for more guidance:

Developed Proposal 2.4: The number of parties that either formally or informally interprets GAAP and the volume of interpretative implementation guidance should

continue to be reduced. The SEC should coordinate with the FASB to clarify roles and responsibilities regarding the issuance of interpretive implementation guidance, as follows:

FASB Codification: The FASB has undertaken a significant project to develop a comprehensive, integrated Codification of existing accounting literature organized by subject matter that is intended to become an easily retrievable single source of GAAP. To that end, on January 16, 2008, the FASB released a draft of the FASB Codification that will be subject to a one-year verification period. We applaud the FASB's foresight on such a project and recognize the significant effort the project has entailed. The FASB Codification:

• Brings together all GAAP from all authoritative sources except the SEC and classifies it by topic into a single, searchable database so that it may be more easily researched.

• Clarifies what guidance is authoritative versus non-authoritative.

• Puts accounting standards into a consistent format, to the extent possible.

Although the FASB Codification does not change the substance of GAAP, it should make its application easier. However, SEC literature, which has developed through different mechanisms, is not as easily integrated into the FASB Codification.

Similarly, the FASB Codification does not deal with either the root causes of the proliferation of interpretive implementation guidance or the behavior of participants in the U.S. financial reporting community that caused the complexity. Notwithstanding these concerns, we support the FASB's efforts to verify the Codification. To further improve the Codification, the SEC should re-codify its guidance using a consistent format, and the FASB and the SEC should consider a second phase of the codification project that would systematically revisit GAAP, as discussed in section VI of this chapter.

Two of the benefits of the FASB Codification are its search feature and decimal system, which consistently organizes topics and subtopics within GAAP. No SEC guidance is currently included in the FASB Codification. To improve its usability in the future, the Codification will include authoritative content issued by the SEC, as well as selected SEC staff interpretations. However, the inclusion of SEC guidance will be for administrative convenience and will not supersede such guidance in its current form. Further, the SEC guidance will not follow the same organizational structure as the rest of GAAP.

Non-Authoritative Guidance: Although the FASB Codification will help clarify the roles of authoritative and non-authoritative guidance, meaningful improvements in financial reporting will be difficult if non-authoritative interpretive implementation guidance continues to be perceived, as it is today, as having quasi-authority in the marketplace. Our proposal is intended to foster acceptance of reasonable professional judgments made in good faith when they are supportable under GAAP. Specifically, non-authoritative interpretive implementation guidance should not be used to force restatements when other reasonable views exist that are supportable under GAAP.

We recognize there is often a need for interpretive implementation guidance and that such guidance can serve an important purpose. The volume of interpretative implementation guidance should be reduced, and it should be clearly identified as non-authoritative.

VI. Conceptual Approaches and Future Considerations

As discussed more fully below, we are considering a number of conceptual approaches and matters for future consideration to improve standards-setting:

Conceptual Approach 2.A: To further reduce interpretive implementation guidance associated with GAAP, we are considering proposing that the SEC further clarify its role vis-à-vis the FASB, as well as its internal roles and responsibilities, to mitigate the risk of its actions unintentionally driving behavior by market participants, as follows:

• The SEC should clarify that registrant-specific matters are not authoritative forms of interpretive implementation guidance under GAAP and, accordingly, registrants other than the specific registrant in question are not required to take into account such registrant-specific matters.

• The SEC staff should refrain from informally communicating broadly applicable interpretive implementation guidance (e.g., staff speeches) that are likely to be perceived as changing the application of GAAP. Rather, such communications should be used to highlight authoritative interpretive implementation guidance that has already been issued.

• In instances in which the SEC staff identifies registrant-specific accounting matters that it believes may result in the need for broader interpretive implementation guidance or a clarification of an accounting standard under GAAP, the SEC staff should refer these items to the FASB as part of the Agenda Advisory Group.

• When it is necessary for the SEC or its staff to issue broadly applicable interpretive implementation guidance, it should try to provide such guidance: (1) In a clear communication identified as authoritative, (2) so that it can easily and immediately be integrated into a codification of SEC literature (as proposed in section V of this chapter), and (3) when expected to significantly change the application of GAAP, only after transparent due process and public comment to the extent practicable.

• The SEC staff should revisit internal procedures and take further steps necessary to improve the consistency of its views on the application of GAAP.

The SEC sometimes issues rules and interpretations that comprise part of authoritative GAAP. The SEC's rule-making activities are generally open to public participation and observation. However, other activities of the SEC and its staff do not occur with the same level of transparent due process and public comment. As discussed below, registrant-specific guidance is published in the form of comment letters, but appropriately does not need to be proposed in advance or subject to public comment. On the other hand, to the extent the SEC promulgates interpretive implementation guidance that is broadly applicable and is expected to significantly change the application of GAAP, we are considering whether it should do so only after public notice and comment, whenever practicable.

Registrant-Specific Guidance: The SEC Division of Corporation Finance (Corp Fin) reviews and comments on financial reports filed by registrants that are not investment companies. Corp Fin has a process for facilitating the public availability of comment letters and registrant responses to these comment letters on the SEC's Web site upon completion of the review process. Corp Fin also receives letters from specific registrants requesting concurrence on various reporting and disclosure issues. Similarly, OCA and Corp Fin receive requests from specific registrants for concurrence on specific interpretative implementation issues. These letters are commonly referred to in the marketplace as “pre-clearance” letters.

Preparers and auditors may misconstrue registrant-specific accounting outcomes as quasi-authoritative. However, registrant-specific matters are appropriately not subject to the same public deliberation and comment as SEC rule-making, because they are registrant-specific and are not intended to be applied more broadly. Nevertheless, preparers and auditors may overreact by applying these outcomes to similar, yet different, transactions, sometimes believing that restatement is required.

We are deliberating whether the SEC should make clear that comments provided to a specific registrant are not binding on other registrants. Clarifying that such comments are non-authoritative would help:

• Prevent preparers and auditors from giving undue significance to SEC staff comments made to individual registrants.

• Reduce the need for other parties to issue interpretive implementation guidance.

• Support our proposal to refer broadly applicable accounting matters that require interpretive implementation guidance to the FASB.

Broadly Applicable Guidance: To inform the public about broadly applicable interpretive implementation guidance, the SEC uses various forms of communication, including SABs,

letters to industry, staff speeches, public announcements, and training manuals. In addition, Corp Fin publishes and maintains interpretive implementation guidance on the SEC's Web site. While all of these publications contain disclaimers as to their non-authoritative nature, many participants in the financial reporting community consider these disclaimers to be boilerplate and regard such interpretive implementation guidance as quasi-authoritative.

The SEC authorized the use of SABs in 1975 to achieve a wider dissemination of the administrative interpretations and practices utilized by the SEC staff in reviewing financial statements. There had been concern that smaller audit firms and issuers would be disadvantaged because there had previously been no formal dissemination of staff practices. SABs were also designed to provide a means by which new or revised interpretations and practices could be quickly and easily communicated to registrants and their advisors. As they are designed to disseminate staff administration practices on a timely basis to the broader public, SABs are generally not exposed for public comment before release.

These publications are typically viewed by the SEC staff as confirmations of existing accounting standards, rather than as supplemental interpretive implementation guidance. However, many of these publications have and continue to influence market behavior because they sometimes include SEC staff views that do, in fact, supplement existing GAAP. The SEC staff sometimes refers registrants to these publications to support their views on registrant-specific matters. As such, many argue that these documents exemplify the SEC staff effectively setting standards without transparent due process and public comment and point to restatements sometimes following the release of these documents as evidence of their quasi-authoritative nature in practice.

In addition, other individual sources of non-authoritative implementation guidance (e.g., audit firms and the CAQ) often publish their own guidance to broadly communicate what they perceive to be SEC staff's views and to drive consistency in practice. However, as discussed below, if the SEC were to increase its formal referral of broadly applicable interpretive matters to the FASB, which could issue guidance in an authoritative, timely fashion, the overall volume of interpretive implementation guidance would be reduced, as would conflicts between interpretations from different sources. We believe this would further influence behaviors that have led to the desire for more guidance.

We recognize that the SEC staff publishes guidance to address issues other than the application of GAAP. This conceptual approach is not directed towards such publications. We also recognize that the SEC staff, based on its review of thousands of filings each year, is in a unique position to publish its comment letters. Such publications are intended to reduce comments that each registrant receives in the review process by promoting a high degree of compliance with GAAP. We continue to consider what proposals to make in this area, but believe that the SEC staff should be diligent when preparing this information not to present comments in a manner that is likely to be perceived as interpretative implementation guidance.

Referral of Issues to the FASB: As discussed in section IV of this chapter, there were a number of standards that were communicated to the FASB that were in need of improvement that have yet to be improved. The SEC should formalize the mechanism by which it refers issues to the FASB, and one of the goals of SEC representation on the proposed Agenda Advisory Group would be to strengthen such a referral mechanism. This will permit the FASB to address the need for authoritative interpretive implementation guidance that is broadly applicable in a codified form, thereby reducing the need for the SEC to do so. It will also give the SEC greater insight into when the FASB and the EITF do not intend to issue interpretive implementation guidance, which will allow the SEC to be more responsive by issuing guidance, in the limited circumstances when necessary.

Consistency: We are considering whether there is a need for more coordination between the various offices and divisions within the SEC to improve the consistency of accounting advice given by the SEC staff. Although there are processes in place to build consensus on accounting matters within the SEC, there may be room for improvement.

The possibility of inconsistent accounting advice emanating from the SEC staff creates confusion in the marketplace.

Two processes exist (one in Corp Fin and one in OCA) for registrants to request reconsideration of conclusions expressed in either comment letters or in pre-clearance letters when registrants disagree with staff guidance or believe they are receiving inconsistent advice compared to other registrants. However, registrants may not always use these processes for a number of reasons, such as: (1) To avoid additional delays and missed market opportunities, (2) to avoid the risk of opening other accounting conclusions to reconsideration, and (3) fear of possible retribution (misguided or not). Therefore, although the SEC staff has created checks-and-balances in the form of reconsideration processes, they may not be utilized as anticipated.

We do not intend to limit the ability of the SEC staff to carry out its regulatory responsibilities in a timely fashion. That is why we have not yet proposed a specific course of action. We understand the SEC staff is reviewing its procedures in many of these areas and expects to unveil a number of changes in the coming months, including new procedures to enhance the consistency

of registrant-specific accounting interpretations during filing reviews and increasing the understanding and usefulness of its reconsideration processes. We support these efforts and plan to review progress with the SEC staff in the coming months as we continue our deliberations.

Conceptual Approach 2.B: We are considering proposing that the SEC continue to encourage improvement in the way standards are written, as follows:

• By supporting the writing of accounting standards according to an agreed-upon framework of what constitutes an optimal standard. Such standards should not strive to answer every question and close every loophole, but should be written with more clearly stated objectives and principles that may be applied to broad categories of transactions.

• By supporting the writing of accounting standards in a manner that promotes trust and confidence in efficient markets by encouraging the use of professional judgments made in good faith. Specifically, preparers and auditors should apply the standards faithfully, and regulators should monitor and address abusive application of the standards.

Optimal Design of Standards: Some participants in the U.S. financial reporting community believe that certain accounting standards do not clearly articulate the objectives and principles upon which they are based, because they are sometimes obscured by detailed rules, examples, scope exceptions, safe harbors, cliffs, thresholds, and bright lines. In addition, GAAP is often not written in plain English. This can create uncertainty in the application of GAAP, as rules cannot cover all possibilities and the underlying principles and objectives may not be clear.

Another significant concern about the current system of accounting standards is that the proliferation of accounting rules fosters accounting-motivated structured transactions. As discussed further in chapter 1, 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 more objectives-oriented (or principles-based) standards may ultimately improve the quality of the financial reporting upon which investors rely.

The question of how to design standards going forward 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 principles-based (or objectives-oriented) standards.

The question of how standards should be designed going forward is a critical aspect of the standards-setting process.

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 als

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