The Rulemaking Process: Two Accounting and Auditing Mini-case Studies

Introduction

Thank you, Michael Turner, for that kind introduction. I’d also like to thank Karen Walker and the Tulsa Chapter of the IMA for the invitation. It’s a pleasure to be here.

I need to begin with the standard SEC disclaimer: my talk does not necessarily reflect the views of the Commission, the Commissioners or the SEC staff.[1]

Let me start by describing the SEC office where I work, the Office of the Investor Advocate. Then I will talk about two mini-case studies: FASB’s proposals to remove its definition of materiality, and the PCAOB’s final rule that, if approved by the SEC, would significantly enhance the audit reporting model.

Our office was established by a statutory mandate of Congress three and a half years ago, and my supervisor, Rick Fleming, is the Commission's first Investor Advocate. He in turn appointed the SEC’s first Ombudsman, who works within our Office to assist retail investors in resolving problems they may have with the Commission or an SRO.

Our Office mission is to be the eyes and ears for investors and, when necessary, to provide a voice for them in Washington. We seek to ensure that the interests of investors are considered as policy decisions are made at the SEC and also at the self-regulatory organizations (SROs) that the Commission oversees.

We enjoy a significant level of independence within the SEC. Our Office makes recommendations to the SEC and directly to Congress. Each year we issue two reports to Congress and, by law, no one at the SEC outside our Office is permitted to review or comment on our Reports before we send them to Congress.

Sometimes we are described as a watchdog, but we believe that it is important for us to work constructively as part of the team with our colleagues at the Commission. We aim to be part of the policymaking process, with a seat at the table while decisions are still being made, rather than standing outside that process and only expressing our views or criticizing decisions after they are made.

We also seek to inform policy decisions by studying investor behavior. We are responsible for conducting investor research, which may encompass surveys, focus groups, and other methods to gain insight into investor behavior and provide data to inform policy choices.

Another of our core activities is to support the work of the SEC Investor Advisory Committee. This is an outside body that provides recommendations to the Commission. The Investor Advocate is a member of the Committee, and I serve as the Commission’s staff liaison to it.

Our Office has a staff of about a dozen people, and each year we review about two dozen SEC rule proposals plus around 300 SRO proposals. To manage the workflow and enhance our impact, we identify half a dozen priorities each year, which include accounting and auditing issues.

Today I’d like to discuss two such issues, one on materiality and the other related to the independent auditor’s report. I will pause at the end of each issue to give you a chance to ask questions. These two mini-case studies are meant to give you a sense of the policymaking process and the dilemmas that policymakers wrestle with. They also will illustrate a fundamental difference between outside investors and managers inside the company, including many of you.

Materiality

As management accountants, you collect, organize, and report financial information that you and other managers and executives at your companies want to see. Investors also have a critical need to see the financial information of the companies in which they invest, and they may use it in many of the same ways that you probably do: to assess the company’s financial position and performance, to predict future cash flow, to weigh financial risks, and to allocate resources efficiently. But there is a big difference between investors and company managers. You are on the inside, and you have access to all the internal information you want; investors are on the outside, and they have no direct access.

In economic terms, investors face informational asymmetries. They must rely on the disclosures that public companies make. Our securities laws and SEC regulations require public companies to provide disclosures in such forms as audited financial statements, quarterly and annual statements on forms 10-Q and 10-K, and individual sections within reports, such as the management discussion and analysis. As our new SEC Chairman, Jay Clayton, recently stated, “Disclosure and materiality have been at the heart of the SEC’s regulatory approach for over eighty years.”[2]

This raises the question of how much information companies should or must disclose. Materiality provides the core answer to this question.[3] We can think of materiality as a screen or threshold that determines what to disclose.

But how do we determine what is material? That leads us to our first topic, a mini-case study of FASB’s proposals to remove its own definition of materiality. FASB, the Financial Accounting Standards Board, is the private-sector entity that sets the authoritative standards of U.S. GAAP, and the SEC oversees FASB.

In 2015, FASB issued a pair of proposed Updates. One[4] would apply to GAAP, and the other would apply to FASB’s Conceptual Framework, which FASB uses as a guide in its own decision-making process but which is not part of GAAP.[5] Both Updates would refer to materiality as a legal concept.

More specifically, in its proposed Update on the Conceptual Framework, FASB proposed to remove its own definition of materiality and instead to rely on the courts to provide the definition. FASB did so, it explained, because, “The Board became aware that the current definition of materiality…was inconsistent with the legal concept of materiality in the United States.”[6]

To correct that inconsistency, FASB proposed to strike the definition of materiality that it had stated in a document called Concepts Statement Number 8, or Con 8 for short. That definition stated:

“Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.”[7]

FASB proposed to replace that definition with new language that essentially said two things: First, materiality is a legal concept; and, second, it is not up to FASB to define it. In FASB’s words:

Materiality is a legal concept. In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality.[8]

FASB went on its proposed Update to cite the Supreme Court definition:

Currently, the Board observes that the U.S. Supreme Court’s definition of materiality, in the context of the antifraud provisions of the U.S. securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information.[9]

What’s the difference between the Supreme Court definition and the one in FASB’s Concept Statement 8? A lot hinges on the difference between the words “could” and “would:” Con 8 defines materiality in terms of what could influence investors and other stakeholders, while the Supreme Court speaks of what would influence investors. That simple one-word change would significantly alter the definition of materiality.

As FASB noted, GAAP Topic 105 already states that accounting standards need not be applied to immaterial items.[10] Nonetheless, FASB found that “some stakeholders were not aware of the overarching principle of materiality in the Accounting Standards Codification, while others were unsure how materiality should be applied to disclosures.”[11] Therefore, FASB described its proposals on materiality as clarifications that were not intended to change any specific disclosure requirements.

I think it is fair to say that FASB did not expect its proposals to stir up the controversy that followed. A number of investors and investor associations voiced vigorous objections, and the SEC Investor Advisory Committee held a public discussion and then weighed in with its own letter to FASB.[12]

Several investors argued that the proposals were based on the mistaken premise that investors were suffering from a purported overload of information.[13] But investors themselves noted that they were not complaining of any information overload. On the contrary, investors, preparers and some accounting firms have been harnessing technology to analyze greater and greater amounts of data. (In fact, the next presentation today will discuss the impact on accounting of one such innovation, Robotic Process Automation.) And yet, according to one commenter, FASB’s proposals would have the effect of reducing the flow of information to investors and therefore was out of step with the times.[14]

Critics also warned that FASB’s proposals would shift decision making on materiality from accountants to lawyers. The SEC Investor Advisory Committee, for example,[15] argued that “by replacing the current, differentiated professional accounting standard with a case-law driven legal standard, close questions of judgment will ultimately devolve to lawyers rather than accountants.”[16]

In fairness to FASB, there were also well-informed commenters who supported the proposals. In the back-and-forth of the arguments in this public debate, a handful of related issues struck me as raising fundamental questions.

First, FASB’s critics point out that the Supreme Court definition of materiality arose in cases involving alleged securities fraud. To demonstrate securities fraud, one must show not only that a statement is misleading, and that investors relied upon it, but also that the defendant had the intent to deceive, manipulate, or defraud.[17] That is a high bar, perhaps too high to set in the context of financial reporting. In other words, a definition of materiality suited to the antifraud provisions of federal securities laws may not be the most suitable in the context of accounting standards.

The Council of Institutional Investors argued:

The legal definition of materiality serves the purpose of delineating a group of actors who should be subjected to criminal and/or civil penalties for misleading investors...The definition of materiality applied in the financial reporting setting serves a different purpose…[18]

But let me say a few words in support of FASB’s position. Even though the Supreme Court first defined materiality in the context of an anti-fraud provision,[19] that definition has since been recognized as applying for any purpose under our federal securities laws and in every type of federal securities law violation.[20] The SEC adopted the Supreme Court definition in 1982 and has used it ever since.[21] The courts also consistently use the same Supreme Court definition. So, too, does the PCAOB, which sets auditing standards for registered public accounting firms.[22] What sense, then, would it make for FASB to stand apart and isolated with its own definition of materiality?

This raises another fundamental question: who gets to decide on the definition (or definitions) of materiality? Some investors look to FASB, as the accounting standard setter, to do so, but, as we saw, FASB itself disclaimed that authority.

But even if FASB is not responsible for defining materiality, where do we turn for authoritative guidance on how to apply that definition? It’s all well and good to recite the Supreme Court definition, but it’s another thing to try to apply it to specific facts and circumstances. And yet, the Investor Advisory Committee asserted, FASB “provides no framework for evaluating whether a disclosure is material, nor does any framework exist in GAAP, particularly for those disclosures that are qualitative in nature….The absence of a framework ensures inconsistent application of the materiality standard.”

I would argue, however, that such guidance does exist, and we find it in two other documents: FASB’s previous Concepts Statement 2 and SEC Staff Accounting Bulletin 99. I’m going to talk a bit about both documents, because our Office believes that they hold the key for the path forward.

It’s helpful to view these two documents on a timeline. In 1980, FASB issued Statement of Financial Accounting Concepts Statement No. 2, known as Con 2. Con 2 provided a definition of materiality, which FASB replaced in 2010 with Con 8. Con 2 cites the Supreme Court definition of materiality, saying, “Until such time as the Supreme Court returns to this question, the Northway case provides the most authoritative judicial definition of what constitutes a material omitted fact.”

Con 2 goes on to explain that definition in the accounting context by distinguishing between materiality and the closely related concept of relevance. Con 2 states:

A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material)… Materiality judgments are concerned with screens or thresholds. Is an item, an error, or an omission large enough, considering its nature and the attendant circumstances, to pass over the threshold that separates material from immaterial items?[23]

Con 2 adds, “The more important a judgment item is, the finer the screen should be,” and it offers several illustrative examples. For instance, “An accounting change in circumstances that puts an enterprise in danger of being in breach of covenant regarding its financial condition may justify a lower materiality threshold than if its position were stronger.” In other examples, the materiality judgment could turn on whether the revenue treatment turned a loss into a profit, or whether a misclassification changed an asset from a noncurrent to a current category. As these examples show, the rich and nuanced treatment of materiality in Con 2 contrasts starkly with the laconic statement in FASB’s 2015 proposed Updates that materiality is a legal concept.

Back to our timeline: In 1999, the SEC staff issued Staff Accounting Bulletin 99, or SAB 99. SAB 99 approvingly references Concepts Statement No. 2 for “stat[ing] the essence of the concept of materiality.” SAB 99 then links the Con 2 formulation to the Supreme Court definition: “This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws.” While the Supreme Court definition speaks of the “total mix” of information, FASB’s Con 2 speaks of “surrounding circumstances.” Nonetheless, SAB 99 makes clear that the two terms are equivalent.[24]

Having established that equivalence, SAB 99 goes on to provide a helpful framework for evaluating materiality decisions in preparing or auditing financial statements. Companies must take into account quantitative factors as well as qualitative factors. SAB 99 offers examples of how misstatements of relatively small amounts that come to the auditor's attention could have a material effect on the financial statements. These include misstatements that change a loss into income or vice versa, or misstatements that hide a failure to meet analysts' consensus expectations.

(I should note that Staff Accounting Bulletins are interpretations by staff, and therefore they do not carry the force of law that comes with a Commission ruling. Nonetheless, one appeals court has found SAB 99 to be “persuasive guidance for evaluating the materiality of an alleged misrepresentation.”[25])

The SEC and its staff have never replaced SAB 99, and it still stands. FASB, however, replaced Concepts Statement 2 with Concepts Statements 8 in 2010. It was Concepts Statement 8 that offered the more expansive definition of materiality, in terms of what could influence users of financial information. FASB crafted that definition at a time when it was seeking, in collaboration with the International Accounting Standards Board (IASB), to harmonize U.S. standards with international standards.

By 2015, however, things had changed. As FASB stated in one of its proposed Updates:

The Board is aware that the discussion of materiality as amended in Concepts Statement 8 would no longer be identical to the definition in the IASB’s Conceptual Framework for Financial Reporting, though both were identical when originally issued....It is preferable that both sets of the Conceptual Framework converge. However, that is not possible in this circumstance because the IASB’s definitions of materiality are not consistent with the legal concept of materiality in the United States.[26]

It is that inconsistency with U.S. law that led FASB to propose rescinding its Con 8 definition of materiality.

Now let me say a few words about the views of our Office. Last month, the Investor Advocate sent a letter to FASB setting out his position. We see merit to both sides of the debate. On the one hand, FASB is right to address the misalignment between Concepts Statement No. 8 and the definition of materiality under U.S. law. On the other hand, we also recognize the valid concerns of investors. Therefore, we proposed a fresh approach that we hope could offer a path forward.

Rather than replacing the Con 8 definition of materiality with a mere observation that materiality is a legal concept, we proposed instead that FASB take a new approach grounded in Con 2 and SAB 99. Doing so, we believe, would resolve several issues. This approach would align FASB’s language with the Supreme Court definition of materiality. It would thus harmonize FASB’s concept of materiality with the SEC approach as well as the PCAOB’s auditing standards. In short, a fresh approach based on Con 2 and SAB 99 would satisfy FASB’s legitimate concerns to make its concept consistent with U.S. law.

At the same time, such an approach would address a number of investors’ concerns. By drawing on the exposition and illustrative examples in SAB 99 and Con 2, a new document would respond to investor demands for a framework or guidance on how to apply the general definition of materiality. This would be seen as encouraging informative disclosures, rather than trying to oversimplify or reduce them. This approach would also address concerns about devolving accounting decisions to lawyers.

The materiality topic remains under consideration by FASB. It held a public roundtable discussion on the topic in March of this year. This gave the opportunity for FASB members, investors, accounting professionals, and others to express a range of views in a substantive discussion. The SEC Investor Advocate and I attended the event, and we came away impressed with the integrity, thoughtfulness, and transparency of FASB’s process of due deliberation.

AUDITOR’S REPORTING MODEL

Now let’s move on from accounting to auditing. We’ve already spoken of the fundamental importance of financial reporting to investors, our capital markets, and our economy. The work of the independent auditor is essential to maintain the integrity of financial reporting and to instill investor confidence. In the words of a former SEC Chairman:

[I]f users of financial data, who often may have little or no contact with the business in question, could not trust in its financial statements, capital formation and lending, as we know it in the United States, could not be carried on as they are today.[27]

You will probably agree with me that those remarks, delivered nearly 40 years ago, ring just as true today.

The independent auditor’s report is the sole document in which the auditor communicates its work to investors. The PCAOB has adopted a new standard that, if approved by the SEC, will expand the report significantly. The standard aims to give readers of the audit report greater insight into the most challenging, subjective and complex aspects of the audit.[28]

For more than 70 years, the auditor’s report for unqualified audits has been a simple, pass-fail report.[29] Arguably, the longevity of the pass-fail model speaks to its long-standing value, but it also stands in contrast to the changes that have been coursing through financial markets and financial reporting for a decade. These changes include greater business complexity and the growing use of accounting estimates and fair value measurements, which contribute to the information asymmetry between investors and management.[30] In light of these considerations, investors and others have long been calling for more informative audit reports. Now the PCAOB has answered these calls by adopting the new standard and submitting it to the SEC for approval.

The heart of the new standard is a requirement for the audit report to identify all critical audit matters, or CAMs, and disclose information on the auditor’s response to each CAM.[31] The new standard defines a CAM as a matter that was communicated or required to be communicated to the audit committee and that meets two further tests:

1. The matter must relate to accounts or disclosures that are material to the financial statements, and,

2. The matter must involve especially challenging, subjective, or complex auditor judgment.

Notice the materiality component of the definition, which was missing from an earlier version. But some preparers and audit firms had objected that the absence of a materiality test could produce immaterial disclosures and, moreover, could heighten liability risk for both companies and their auditors. In response, the PCAOB added the materiality component and also took other steps to narrow the definition of critical audit matters.

This later version, however, drew criticism from both sides. Some commenters, mainly preparers and audit firms, argued that the definition was still too broad, while others, including investors, argued that it was too narrow. As some investors observed, accounting fraud or other material accounting problems often start out small and build up over time. Investors are better served when the audit report includes disclosures of these early warning signs, before they grow to have a material impact on the financial statements. Therefore, these commenters objected to a materiality component to the CAMs definition.

In light of our earlier discussion of the FASB debate on materiality, it’s noteworthy that the PCAOB final proposal includes a footnote that states:

The definition of materiality is established under the U.S. federal securities laws. In interpreting those laws, the U.S. Supreme Court has held that a fact is material if there is "a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."[32]

One year ago, on Aug. 15, 2016, the SEC Investor Advocate submitted a comment letter to the PCAOB encouraging it to adopt its proposed standard as a final rule.[33]

We noted that investors want to hear directly from auditors, whose independence and unique perspective give special credibility and value to their insights. We argued that the communication of critical audit matters would “add to the total mix of information, contributing to the ability of investors and others to analyze companies, form a multifaceted understanding of them, and make informed investment decisions.”

We suggested three ways in which investors could use CAMs:

1. CAM disclosures can serve to focus users’ attention on key financial reporting issues and identify areas that deserve more attention. For example, an investor may find that a set of CAMs confirms his or her analysis of key audit issues, or, alternatively, may surprise the investor and point the way for further analysis.
2. The disclosures can facilitate a more focused and richer dialogue between investors and the company. Even without providing original information about the company, the communication of CAMs can highlight areas that investors may wish to emphasize in their engagement with a company. If a critical audit matter is important enough to merit a conversation between the auditor and the audit committee, investors may determine that it could also merit discussion in their conversations with management.
3. The disclosures offer important information that investors can use in making proxy voting decisions, including ratification of auditors.

In addition, we suggested that the impact of CAMs could go beyond investors:

CAMs may have a salutary effect on the behavior of auditors, company management, corporate boards and their audit committees. By heightening the focus on critical audit matters, the communication of CAMs may provide incentives for preparers, corporate managers and audit committees to provide better disclosures, adopt more widely accepted financial reporting approaches, and enhance audit quality. That’s a win-win for investors and companies alike – as well for our capital markets and economy at large.

Frankly, we hoped that our letter could help in the effort to push this rule over the goal line. It had been a long time in the making, and we would not want to see it stalled. The PCAOB first took up the rule seven years ago, in 2010, and since then had held public meetings, issued a concept release and received public comments on it, proposed a new standard and received public comments on that, revised and re-proposed the standard in May 2016, and received public comments once again. So we were happy when, on June 1 of this year, the PCAOB adopted the final rule and submitted it to the SEC for approval.

Conclusion

In conclusion, let me reiterate three points. First, I hope that I’ve given you a sense of the work of policymaking – and the challenge of striking the right balance between competing interests and viewpoints to produce a regulation that accomplishes the three-part mission of the SEC: to protect investors, to ensure fair, orderly and efficient markets, and to facilitate capital formation.

Second, the two examples we’ve discussed – the materiality debate and the expanded audit report – illustrate policymakers’ efforts to reduce the informational asymmetries that investors inevitably face as outsiders.

That leads to my third and final point, which is to emphasize the importance of your work, not only for producing financial information for use by management inside your companies, but also ultimately to provide the financial disclosures that investors rely upon, that are indispensable to our capital markets and our economy, and that benefit all of us. And so I close by quoting SEC Chief Accountant Wesley Bricker, who recently remarked to another group of accountants:

When accountants do their jobs well by producing high-quality financial information, that information energizes our capital markets, enabling domestic and foreign companies alike to obtain funding to support and grow their businesses, creating investment opportunities, jobs and other benefits for the U.S. economy…. Investors, issuers, and the markets all depend on the work you do and the judgments you make…[34]

Thank you.