[Federal Register: February 28, 2008 (Volume 73, Number 40)]
[Notices]
[Page 10897-10939]
[DOCID:fr28fe08-124]

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

Part III

Securities and Exchange Commission

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

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

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

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<EMAIL_ADDRESS>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<PHONE_NUMBER>, 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, Sec.  10(a), James L.
Kroeker, Designated Federal Officer of the Committee, has approved
publication of this release at the request of the Committee. The
solicitation of comments is being made solely by the Committee and
not by the Commission. The Commission is merely providing its
facilities to assist the Committee in soliciting public comment from
the widest possible audience.

    Dated: 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 \1\
---------------------------------------------------------------------------

    \1\ 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,\2\ while reducing the complexity of the
financial reporting system to investors, companies, and auditors.
---------------------------------------------------------------------------

    \2\ 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,\3\ 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.
---------------------------------------------------------------------------

    \3\ 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.\4\
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).
---------------------------------------------------------------------------

    \4\ 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.\5\ The main themes are:
---------------------------------------------------------------------------

    \5\ 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.\6\ 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.
---------------------------------------------------------------------------

    \6\ 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,\7\ 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).
---------------------------------------------------------------------------

    \7\ 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.\8\ (Chapter 1--developed proposal 1.1)
---------------------------------------------------------------------------

    \8\ 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:
    [cir] XBRL-tagged face of the financial statements.\9\
---------------------------------------------------------------------------

    \9\ To allow this first phase, the SEC EDGAR system must permit
submissions using the new XBRL U.S. GAAP Taxonomy.
---------------------------------------------------------------------------

    [cir] Block-tagged footnotes to the financial statements.\10\
---------------------------------------------------------------------------

    \10\ 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) \11\
---------------------------------------------------------------------------

    \11\ 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.
---------------------------------------------------------------------------

    \12\ 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\12\

I. Our Objective

    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,\13\ while reducing the complexity of the
financial reporting system to investors, companies, and auditors.
---------------------------------------------------------------------------

    \13\ 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.\14\ 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.
---------------------------------------------------------------------------

    \14\ 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

    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.
    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,\15\ 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.
---------------------------------------------------------------------------

    \15\ 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.
---------------------------------------------------------------------------

    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.\16\ 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).
---------------------------------------------------------------------------

    \16\ 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.\17\ Second, alternative accounting
policies give preparers options among acceptable practices, such as
whether or not to apply hedge accounting,\18\ 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.
---------------------------------------------------------------------------

    \17\ 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.
    \18\ 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,\19\ where a mere 1%
difference leads to very different accounting.
---------------------------------------------------------------------------

    \19\ 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,\20\ 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 below).
---------------------------------------------------------------------------

    \20\ 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.
---------------------------------------------------------------------------

    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.\21\
---------------------------------------------------------------------------

    \21\ 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.

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

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.\22\
---------------------------------------------------------------------------

    \22\ 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.\23\ 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).\24\ 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.
---------------------------------------------------------------------------

    \23\ 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.
    \24\ 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).\25\ 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.
---------------------------------------------------------------------------

    \25\ 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.\26\ 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.
---------------------------------------------------------------------------

    \26\ 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.\27\ Examples of optionality in GAAP
include:\28\
---------------------------------------------------------------------------

    \27\ For example, companies are free to choose from among
several depreciation methods--straight-line, double-declining
balance, etc.
    \28\ 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.\29\
---------------------------------------------------------------------------

    \29\ 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.\30\ Management intent is a present assertion about management's
plans for future courses of action.\31\
---------------------------------------------------------------------------

    \30\ 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.
    \31\ 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 \32\ 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.
---------------------------------------------------------------------------

    \32\ 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.\33\
---------------------------------------------------------------------------

    \33\ 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,\34\ where a mere 1%
difference in the results of the quantitative tests leads to very
different accounting.
---------------------------------------------------------------------------

    \34\ 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 \35\
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.
---------------------------------------------------------------------------

    \35\ FASB Interpretation No. (FIN) 46 (revised December 2003),
Consolidation of Variable Interest Entities (FIN 46R).
---------------------------------------------------------------------------

    Similarly, the business combination literature \36\ 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.
---------------------------------------------------------------------------

    \36\ 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.\37\ We will also
consider whether improvements related to certain existing,
particularly-complex, standards that incorporate fair value, such as
SFAS Nos. 133 \38\ and 140,\39\ are warranted in the near-term.
---------------------------------------------------------------------------

    \37\ 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.
    \38\ Accounting for Derivatives and Hedging Activities.
    \39\ 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.\40\ 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:
---------------------------------------------------------------------------

    \40\ 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 \41\

    As 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.
---------------------------------------------------------------------------

    \41\ 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.\42\ 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.
---------------------------------------------------------------------------

    \42\ 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.
     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.
    FAF: Our proposal complements the FAF's recently proposed
governance reforms.\43\ 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.
---------------------------------------------------------------------------

    \43\ 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:
     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