Subcommittee Reports of the SEC Advisory Committee on Improvements to Financial Reporting, 29808-29832 [E8-11276]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 73, Number 100 (Thursday, May 22, 2008)]
[Notices]
[Pages 29808-29832]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-11276]


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SECURITIES AND EXCHANGE COMMISSION

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


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

AGENCY: Securities and Exchange Commission.

ACTION: Request for comments.

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

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

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

Electronic Comments

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

Paper Comments

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

All submissions should refer to File No. 265-24. This file number 
should be included on the subject line if e-mail is used. To help us 
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method. The Commission will post all comments on its Web site (https://
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available for public inspection and copying in the Commission's Public 
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identifying information from submissions. You should submit only 
information that you wish to make available publicly.

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

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

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

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

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

Exhibit A

SEC Advisory Committee on Improvements to Financial Reporting

Substantive Complexity Subcommittee Update

May 2, 2008 Full Committee Meeting

I. Introduction

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

[[Page 29809]]

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

 II. Exceptions to General Principles

II.A. Industry-Specific Guidance

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

II.B. Alternative Accounting Policies

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

II.C. Scope Exceptions

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

II.D. Competing Models

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

[[Page 29810]]

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

III. Bright Lines

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

[[Page 29811]]

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

[[Page 29812]]

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

IV. Mixed Attribute Model

    As previously noted in the Progress Report, the mixed attribute 
model is one in which the carrying amounts of some assets and 
liabilities are measured at historic cost, others at lower of cost or 
market, and still others at fair value. There are several measurement 
attributes that currently exist in GAAP, all of which result in 
combinations and subtotals of amounts that are not intuitively useful. 
This complexity is compounded by requirements to record some 
adjustments in earnings, while others are recorded in equity (i.e., 
comprehensive income). For example, changes in the fair value of a 
derivative may be charged directly to equity, while an asset's current 
period depreciation expense reduces net income.
    Optimally, the FASB should develop a consistent approach to 
determine which measurement attribute should apply to different types 
of business activities. While Subcommittee I is aware the FASB has a 
long-term project to develop such an approach, known as the measurement 
framework, it advocates three steps in the near term for the 
Committee's consideration to improve the clarity of financial 
statements for investors.
    First, the Committee should advise caution about expanding the use 
of fair value in financial reporting until a number of practice issues 
are better understood and resolved, providing time for the FASB to 
complete its measurement framework. Second, the Committee should 
recommend a presentation of distinct measurement attributes on the face 
of the primary financial statements, grouped by business activities. 
This will make subtotals of individual line items in the statements 
more meaningful. Third, the Committee should propose the development of 
a disclosure framework, which would enable users to better understand 
the key risks and uncertainties associated with different measurement 
attributes (refer to section V below).
    Preliminary Hypothesis 4: Avoidable complexity caused by the mixed 
attribute model should be reduced in three respects:
     Measurement framework--The SEC should recommend that the 
FASB be judicious in issuing new standards and interpretations that 
expand the use of fair value in areas where it is not already 
required,\14\ until completion of a measurement framework. The SEC 
should also recommend that, to the maximum extent feasible, the FASB 
use a single measurement attribute for each type of business activity 
presented in the financial statements.\15\
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    \14\ For instance, improvements to certain existing, 
particularly complex standards, such as SFAS No. 133, Accounting for 
Derivatives and Hedging Activities and SFAS No. 140, Accounting for 
Transfers and Servicing of Financial Assets and Extinguishments of 
Liabilities, may be warranted in the near term.
    \15\ To make this approach operational, the FASB might establish 
a rebuttable presumption in favor of a single measurement attribute 
within each business activity (i.e., operating, investing and 
financing). For example, the Board may determine amortized cost is 
the presumptive measurement attribute within the operating section 
of a company's financial statements. Nevertheless, the Board would 
also have to consider whether fair value is appropriate for 
financial assets and liabilities employed in those business 
activities, such as certain derivative contracts used to hedge 
commodity price risk for materials used in the production process.
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     Financial statement presentation--The SEC should encourage 
the FASB to:
    [cir] Assign a single measurement attribute within each business 
activity that is consistent across the financial statements.
    [cir] Aggregate business activities into operating, investing and 
financing sections.\16\
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    \16\ Subcommittee I is aware of the FASB and IASB's joint 
financial statement presentation project and is generally supportive 
of its direction. Subcommittee I also notes that in addition to the 
three business activities listed here, the FASB's project 
contemplates two additional types of business activities--income 
taxes and discontinued operations.

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[[Page 29813]]

    [cir] Add a new primary financial statement to reconcile the 
statements of income and cash flows by measurement attribute.\17\
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    \17\ An example of this presentation is included below.
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     Enhanced disclosure--refer to section V of this report.
Background
    As the Committee noted in the Progress Report, examples of 
accounting standards that result in mixed attribute measurement include 
two FASB standards related to financial instruments. SFAS No. 159, The 
Fair Value Option for Financial Assets and Financial Liabilities, 
permits the fair valuation of certain assets and liabilities. As a 
result, some assets and liabilities are measured at fair value, while 
others are measured at amortized cost or some other basis. SFAS No. 
115, Accounting for Certain Investments in Debt and Equity Securities, 
requires certain investments to be recognized at fair value and others 
at amortized cost.
    In practice, the costs associated with (potentially uncertain) fair 
value estimates can be considerable. Some preparers' knowledge of 
valuation methodology is limited, requiring the use of valuation 
specialists. Auditors often require valuation specialists of their own 
to support the audit. Some view the need for these valuation 
specialists as a duplication of efforts, at the expense of the 
preparer. In addition, there are recurring concerns about second-
guessing by auditors, regulators, and courts in light of the many 
judgments and imprecision involved with fair value estimates. 
Regardless of whether such estimates are prepared internally or by 
valuation specialists, the effort and elapsed time required to 
implement and maintain mark-to-model fair values is significant. For 
these reasons, preparers and auditors will likely have to incur costs 
to broaden their proficiency in basic valuation matters,\18\ and 
additional education may be required for the larger financial reporting 
community to become further accustomed to fair value information.
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    \18\ For instance, additional training for field auditors may be 
necessary to lessen dependency on valuation experts.
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    Nevertheless, some have advocated mandatory and comprehensive use 
of fair value as a solution to the complexities arising from the mixed 
attribute model. However, opponents argue that this would only shift 
the burden of complexity from investors to preparers and auditors, 
among others. Specifically, certain investors may find uniform fair 
value reporting simpler and more meaningful than the current mixed 
attribute model. But under a full fair value approach, some objectivity 
would be sacrificed because many amounts that would change to fair 
value are currently reported on a more verifiable basis, such as 
historic cost. These amounts would have to be estimated by preparers 
and certified by auditors, as discussed above. Such estimates are made 
even more subjective by the lack of a single set of generally accepted 
valuation standards and the use of inputs to valuation models that vary 
from one company to the next. Likewise, significant variance exists in 
the quality, skill, and reports of valuation specialists, which 
preparers have limited ability to assess. Finally, there is no 
mechanism to ensure the ongoing quality, training, and oversight of 
valuation specialists. As a result, some believe a wholesale transition 
to fair value would reduce the reliability of financial reports to an 
unacceptable degree.
    Therefore, as the Committee noted in its Progress Report, 
Subcommittee I assumes that a complete move to fair value is most 
unlikely. Within this context, the partial use of fair value increases 
the volume of accounting literature. Said differently, when more than 
one measurement attribute is used, guidance is required for each one. 
In addition, some entities may operate under the impression that 
investors are averse to market-driven volatility. Consequently, 
entities have demanded exceptions from the use of fair value in 
financial reporting, resisted its use, and/or entered into transactions 
that they otherwise would not have undertaken to artificially limit 
earnings volatility. These actions have resulted in a build up in the 
volume of accounting literature. More generally, some believe that 
attempts by companies to smooth amounts that are not smooth in their 
underlying economics reduce the efficiency and the effectiveness of 
capital markets.
    With respect to users, information delivery is made more difficult 
by fair value. Investors may not understand the uncertainty associated 
with fair value measurements (i.e., that they are merely estimates and, 
in many instances, lack precision), including the quality of unrealized 
gains and losses in earnings that arise from changes in fair value. 
Some question whether the use of fair value may lead to 
counterintuitive results. For example, an entity that opts to fair 
value its debt may recognize a gain when its credit rating declines. 
Others question whether the use of fair value for held to maturity 
investments is meaningful. Finally, preparers may view disclosure of 
some of the inputs to the assumptions as sensitive and competitively 
harmful.
    Despite these difficulties, the use of fair value may alleviate 
some aspects of avoidable complexity. Such information may provide 
investors with management's perspective, to the extent management makes 
decisions based on fair value, and it may improve the relevance of 
information in many cases, as historical cost is not meaningful for 
certain items.
    Fair value may also enhance consistency by reducing confusion 
related to measurement mismatches. For example, an entity may enter 
into a derivative instrument to hedge its exposure to changes in the 
fair value of debt attributable to changes in the benchmark interest 
rate. The derivative instrument is required to be recognized at fair 
value, but, assuming no application of hedge accounting or the fair 
value option, the debt would be measured at amortized cost, resulting 
in measurement mismatches. In addition, fair value might mitigate the 
need for detailed application guidance explaining which instruments 
must be recorded at fair value and help prevent some transaction 
structuring. Specifically, if fair value were consistently required for 
all similar activities, entities would not be able to structure a 
transaction to achieve a desired measurement attribute.
    Fair value also eliminates issues surrounding management's intent. 
For example, entities are required to evaluate whether investments are 
impaired. Under certain impairment models, entities are currently 
required to assess whether they have the intent and ability to hold the 
investment for a period of time sufficient to allow for any anticipated 
recovery in market value. As the Committee noted in the Progress Report 
(see discussion supporting developed proposal 1.2 to minimize 
alternative accounting policies) management intent is subjective and, 
thus, less auditable. However, use of fair value would generally make 
management intent irrelevant in assessing the value of an investment.
Discussion
    Subcommittee I acknowledges the view that a complete transition to 
fair value would alleviate avoidable complexity resulting from the 
mixed attribute model. However, Subcommittee I also recognizes that 
expanded use of fair value would increase avoidable complexity unless 
numerous implementation questions related to relevance and reliability 
are

[[Page 29814]]

addressed (as discussed above), which extend beyond the scope of our 
work.
    Therefore, consistent with current practice, Subcommittee I 
preliminarily believes fair value should not be the only measurement 
attribute in GAAP. At present, Subcommittee I believes the Committee 
should advise caution about expanding the use of fair value until a 
systematic measurement framework is developed, and in this regard, that 
phase two of the FASB's fair value option project, which will consider 
permitting fair value measurement for certain nonfinancial assets and 
liabilities, should not be finalized prior to completion of a 
measurement framework.\19\
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    \19\ Similarly, Subcommittee I preliminarily believes the 
Committee should recommend that the FASB consider deferring 
provisions of new standards that are issued, but not yet effective, 
which expand the use of fair value measurement where it has not been 
previously required.
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    At that point, the FASB should determine measurement attributes 
based on considerations such as business activity, the relevance and 
reliability of fair value inputs, and other considerations vetted 
during the measurement phase of its conceptual framework project. While 
Subcommittee I prefers an activity-based approach to assigning 
measurement attributes, Subcommittee I is sympathetic to an approach 
based on the type of asset or liability in question, such as financial 
instruments vs. non-financial instruments. This is a natural tension 
that the FASB should address as part of the measurement framework. For 
example, in one scenario, the Board may determine amortized cost is the 
presumptive measurement attribute within the operating section of a 
company's financial statements. Nevertheless, the Board would also have 
to consider whether fair value is appropriate for financial assets and 
liabilities employed in those business activities such as certain 
derivative contracts used to hedge commodity price risk for materials 
used in the production process.
    With respect to financial statement presentation, Subcommittee I 
preliminarily believes the grouping of individual line items (and 
related measurement attributes) by operating, investing and financing 
activities would alleviate some of the concerns about fair value in 
particular. It would also reduce confusion caused by the commingling of 
all measurement attributes. Subcommittee I preliminarily believes this 
presentation would be more understandable to investors, particularly 
because it would delineate the nature of changes in income (e.g., fair 
value volatility, changes in estimate) and allow users to assess the 
degree to which management controls each one.
    It may also facilitate earnings analyses by business activities 
that correspond to the natural elements of most profit-driven entities, 
for instance, operating income compared to investing or financing 
results. Under this approach, companies should present earnings per-
share computations of the net activity in each section. Further, the 
addition of a new primary financial statement--the reconciliation of 
the statements of comprehensive income and cash flows--would 
disaggregate changes in assets and liabilities based on cash, accruals, 
and changes in fair value, among others. A visual example of this 
statement might include the following: \20\
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    \20\ Subcommittee I has adapted and modified this table from a 
similar schedule in the FASB's financial statement presentation 
project.

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

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

[[Page 29815]]

FASB on the joint financial statement presentation project.

V. Disclosure Framework

    Disclosure provides important context for the estimates and 
judgments reflected in the financial statements. It also highlights 
uncertainties outside of the statements that could impact financial 
performance in the future.
    Subcommittee I preliminarily believes that any recommendations 
regarding new disclosure guidance will be most effective and 
informative for investors if the FASB and SEC update, or as necessary, 
rescind outdated or duplicative disclosure requirements. Subcommittee 
I's preliminary hypothesis advocates establishing a process to achieve 
this goal.
    Preliminary Hypothesis 5: The SEC should request the FASB to 
develop a disclosure framework to:
     Require disclosure of the principal assumptions, estimates 
and sensitivity analyses that may impact a company's business, as well 
as a qualitative discussion of the key risks and uncertainties that 
could significantly change these amounts over time. This would 
encompass transactions recognized and measured in the financial 
statements, as well as events and uncertainties that are not recorded, 
such as certain litigation and regulatory developments.
     Integrate existing disclosure requirements into a cohesive 
whole by eliminating redundant disclosures and providing a single 
source of disclosure guidance across all accounting standards.
    The SEC and FASB should also establish a process of coordination 
for the Commission to regularly update and, as appropriate, remove 
portions of its disclosure requirements as new FASB standards are 
issued.\21\
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    \21\ The Committee considers coordination between the SEC and 
the FASB in chapter 2 of the Progress Report, particularly 
conceptual approaches 2.A and 2.C.
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Background
    Historically, disclosure standards have developed in a piecemeal 
manner (i.e., standard-by-standard). The lack of an underlying 
framework has contributed to (1) Repetitive disclosures, (2) 
excessively detailed disclosures that may confuse rather than inform, 
and (3) disorganized presentations in financial reports. These factors 
make fulsome and meaningful communication of all material information 
challenging.
    As noted above, disclosure provides important context for the 
estimates and judgments reflected in the financial statements. However, 
Subcommittee I acknowledges the perception that amounts recognized in 
financial statements are generally subject to more refined calculations 
by preparers and higher degrees of scrutiny by users compared to mere 
disclosure. As a result, the effectiveness of disclosure standards--
whether existing or new--will be governed by the degree to which 
constituents view them as another compliance exercise rather than an 
avenue for meaningful dialogue.
    Subcommittee I preliminarily believes that a disclosure framework 
would facilitate this meaningful dialogue between preparers and users. 
In order for such a disclosure framework to be useful over the long-
run, however, it should establish objectives, whose application will 
vary. Otherwise, disclosure standards will degenerate into myriad rules 
because it is not feasible for standards-setters to envision all of the 
specific future disclosure requirements that would be necessary in 
different settings.
    For example, in the wake of the recent ``liquidity crisis,'' there 
has been significant focus on disclosures related to off-balance-sheet 
entities. Of particular interest is disclosure of structured investment 
vehicles (SIVs).\22\ Recently, certain sponsoring banks have provided 
liquidity support to SIVs that were unable to sustain financing in the 
short-term commercial paper market. In some cases, this led the 
sponsors to consolidate the SIVs under FASB Interpretation No. 46(R), 
which added billions of dollars of assets and liabilities to the 
sponsors' balance sheets. Consequently, some constituents have 
criticized existing disclosure practices and called for standards-
setters to require additional ``early warning'' disclosure about off-
balance sheet activity (e.g., types of assets held by the SIVs, 
circumstances that may result in consolidation or loss, and 
methodologies used to determine fair value and related write-downs). 
Others counter that: (1) Major SIV sponsors already disclosed the 
magnitude of their investments in off-balance sheet entities prior to 
the liquidity crisis and (2) further detail would have been 
uninformative and potentially confusing to users because it would have 
amounted to ``disclosure overload.'' For instance, at the time the 
decision not to consolidate was reached, some sponsors may have 
concluded it was quite unlikely that events which might lead to 
consolidation would actually occur, and that discussion of these 
scenarios was unnecessary. These two opposing points of view highlight 
the tension noted above, namely, that some constituents prefer 
detailed, prescriptive disclosure guidance, while others favor a more 
principled approach.
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    \22\ From a review of SEC filed documents, Subcommittee I has 
identified seven SEC filers that sponsored SIVs around the time of 
the liquidity crisis. Prior to the crisis, most of these filers did 
not provide quantified disclosure of the unconsolidated SIVs' assets 
and liabilities (in some cases, SIV assets and liabilities were 
aggregated with the assets and liabilities of other off-balance 
sheet arrangements--collectively, ``VIEs''). Subsequent to the 
crisis, Subcommittee I notes that some sponsors have expanded their 
disclosures to include additional quantitative information, as well 
as qualitative disclosures such as the nature of SIV assets, 
descriptions of SIV investment and operating strategies, risks 
related to the current environment, and sponsors' obligations to the 
SIVs.
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Discussion
    Specifically, Subcommittee I preliminarily believes that at a 
minimum, an effective disclosure framework is comprised of three basic 
elements: (1) A description of the transactions reflected in financial 
statement captions, (2) a discussion of the relevant accounting 
provisions, and (3) an analysis of the key supporting judgments, risks 
and uncertainties.\23\ In the following commentary, we focus largely on 
the third element.
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    \23\ Subcommittee I acknowledges the work of the FASB's 
Investors Technical Advisory Committee on the topic of a disclosure 
framework. Subcommittee I preliminarily agrees with the need to 
establish a principles-based approach to future disclosure standards 
and has adapted certain elements of ITAC's thinking in this 
discussion.
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    Within the financial statements, a disclosure framework should more 
effectively signal to investors the level of imprecision associated 
with significant estimates and assumptions, particularly some fair 
value measurements. This can be achieved by disclosing the principal 
assumptions, estimates and sensitivity analyses that impact a company's 
business, as well as a qualitative discussion of the key risks and 
uncertainties that could significantly change these amounts over time. 
For example, Subcommittee I notes that in certain cases, there is no 
``right'' number in a probability distribution of figures, some of 
which may be more fairly representative of fair value than others. 
While SFAS No. 157, Fair Value Measurements, established disclosure 
requirements that provide insight into Level 2 and 3 fair value 
estimates,\24\ it may not be sufficient in all cases. Many investors 
might find information about the key assumptions in a valuation model, 
key risks

[[Page 29816]]

associated with those assumptions,\25\ and related sensitivity analyses 
helpful, as well as an understanding of how ``fat'' or ``thin'' the 
tails of statistical modeling techniques are.\26\
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    \24\ Statement 157 established a three level fair value 
hierarchy. It assigns highest priority to quoted prices in active 
markets (Level 1) and the lowest priority to unobservable inputs 
that rely heavily on assumptions (Level 3).
    \25\ For example, if a valuation model relies on historical 
assumptions for a period of time that does not include economic 
downturns, that fact and its implications may need to be disclosed.
    \26\ In statistics, this notion is known as the ``goodness of 
fit,'' which describes how well a statistical model fits a set of 
observations. These are quantified measures that summarize the 
discrepancy between observed values compared to values predicted by 
the model. Large discrepancies can be described as ``fat,'' while 
small discrepancies are ``thin.''
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    Outside of the financial statements, disclosure of environmental 
factors may be more meaningful than attempting to ``force'' a wide 
range of probabilities into a single point estimate on the balance 
sheet or income statement. This would encompass events and 
uncertainties such as relevant market conditions, off-balance sheet 
activity, litigation and regulatory developments. Some constituents 
argue that recording an estimate to reflect these events, instead of 
disclosing them,