Seeking Clarity: Robert Pozen

Robert Pozen is chairman of MFS Investment Management and was recently appointed chairman of the new SEC Advisory Committee on Improvements to Financial Reporting (CIFiR). He recently answered questions from the JofA.*

* Mr. Pozen’s comments do not necessarily reflect the views of the committee, other committee members, the SEC or its staff.

JofA: What is the ultimate goal of CIFiR, and how will you measure progress toward achieving it?

Pozen: The SEC established CIFiR in order to develop recommendations to reduce unnecessary complexity in the financial reporting system and make financial reports more useful to investors. We will measure progress initially by whether we can produce by August 2008 a set of sensible and doable recommendations in those two areas. We are aiming at taking practical steps forward, rather than revolutionizing the reporting system.

We are formulating proposals that can be implemented by the SEC, FASB or PCAOB, while staying away from any proposal that would require legislative action. Over time, we will measure the success of the CIFiR on whether a significant portion of our recommendations are actually adopted by these organizations and prove to be effective.

JofA: Why have prior efforts to address complexity in financial reporting failed, and why do you believe that your fate will be different?

Pozen: One of our objectives is to reduce “unnecessary” complexity, not all complexity. If we can understand the reasons for complexity, we will have a better chance of making effective proposals. For example, are financial reports complex because the transactions are complex or because we allow too many industry exemptions and alternative treatments?

Second, this is a committee set up by the SEC, with the support of other boards, that together have the power to change the financial reporting rules. The SEC has asked for recommendations because it wants to improve financial reporting. By contrast, many prior efforts were sponsored by business, nonprofit or academic groups that did not necessarily have the power to change financial reporting rules.

JofA: Your charter is set to expire Aug. 2, 2008. Is a year enough time for such a gargantuan task? Is it possible you will make recommendations to the SEC in less than 12 months?

Pozen: We are trying to generate a relatively modest number of recommendations (for example, 10 to 15) that can be implemented by the SEC or FASB or PCAOB within a reasonable time frame. As discussed above, we are not aiming at bringing about a totally new concept of financial reporting; rather, we are trying to improve upon the existing system for financial reporting.

We intend to submit a set of such recommendations to the SEC by Aug. 2, 2008. However, the SEC can provide us with an extension of a few months if needed. On the other hand, we may make some interim recommendations before Aug. 2, 2008, to expedite the implementation process.

JofA: How do you reconcile the need for long-term sweeping changes with the need for recommendations that can have a short-term impact?

Pozen: As mentioned above, we will be concentrating on making proposals that are sensible and doable within a reasonable time frame. Nevertheless, some of these proposals could involve what might be seen as sweeping changes—for example, delivering financial information in different packages appropriate for different types of investors.

Other proposals might be the first step down a road toward sweeping changes—for example, suggesting an income statement that more clearly and effectively distinguishes between realized and unrealized earnings.

JofA: Do you intend to coordinate your work and recommendations with the Treasury Department’s Advisory Committee on the Auditing Profession? If so, how will the two committees coordinate their work and recommendations?

Pozen: In addressing compliance with financial reporting rules, we will be aware of the legal liabilities and sustainability challenges confronting the audit profession. However, we will not make proposals in these areas since they will be the focus of the work of the U.S. Treasury committee.

We have an observer from the U.S. Treasury who will sit in on the meetings of the CIFiR. At the same time, the staff of the CIFiR will monitor the progress of the U.S. Treasury committee. It is too early to tell exactly how the recommendations of both committees will be coordinated.

JofA: How do you combine rules-based instructions with the principles-based look at the economic substance of the business?

Pozen: Much of the debate on a principles-based vs. rules-based approach is not constructive. In a good financial reporting system, both principles and rules have important roles to play.

First, principles must be articulated in order to guide the writing of rules. Second, principles allow rules not to be written in certain areas—just apply the principles. Third, we can have rules that are designed to implement the general principles covering a transaction, but we can say that principles take precedence over those rules if the precise application of those rules to a transaction leads to a misleading picture for investors. This third point shows how rules-based instructions can be combined with a principles-based look at the economic substance of a transaction.

JofA: Is the quality of audits a concern when implementing more principles-based financial reporting standards?

Pozen: When we move away from rules and toward a principles-based system of financial reporting, we face certain inherent limitations. Principles require auditors to exercise more judgment, so there is inevitably a higher degree of subjectivity in accounting for a particular transaction. As a result of such subjective judgments, there may be less comparability among multiple audits of similar transactions.

However, these limitations of a principles-based approach must be weighed against the disadvantages of relying exclusively on detailed rules. Such reliance may encourage issuers and their auditors to redesign transactions primarily to avoid a brightline test. Similarly, rigid adherence to detailed rules can sometimes limit the auditor’s ability to ascertain the economic substance of a transaction. Again, we need an appropriate combination of principles and rules.

JofA: How can more principles-based standards work in the United States if preparers and auditors have a constant fear of being second-guessed by regulators and in litigation?

Pozen: The threat of second-guessing is a significant constraint on the use of principles- based standards in the United States. No one wants to exercise judgment and later be sued on that judgment call. One big advantage of rules is that they offer a degree of legal comfort—if an issuer or auditor follows a rule, that would be an important defense in the
event of litigation.

If regulators decide to move toward a more principles-based system, they will probably have to give more deference to the judgment exercised by preparers and auditors in applying those principles. This could be implemented, for example, through the adoption by the SEC and the PCAOB of a rule permitting a defense based on good faith judgment or reasonable choice among alternatives.

Preparers and auditors may also have to stand ready to supply enhanced disclosures about their significant judgments. However, it is less predictable how the courts would react to the judgment calls made by preparers or auditors in applying a principles-based approach.

JofA: How do you balance the need for uniform, firm-wide audit procedures and the use of auditors’ professional judgment?

Pozen: In order to promote quality control, audit firms have increasingly turned to firm-wide audit procedures. If these procedures are expressed as detailed rules, they are easier to follow and enforce on a firm-wide basis. They also help to reduce audit costs.

However, audit firms could establish presumptive rules that could be overridden by the judgment of the engagement partner. The engagement partner could be required to consult in advance with the national expert or, alternatively, include in his or her audit workpapers the rationale for deviating from the presumptive role. Such procedures allowing for judgment would require different types of training programs by audit firms.

JofA: The number of restatements has increased dramatically over the last several years. Do you think more restatements are being made on issues that are not material to investors? If so, how can this be changed?

Pozen: The committee will be examining why the number of restatements has increased so much over the last few years. This increase may be related to various factors. For example, some claim that many restatements have resulted from speeches or letters from government officials with new views of existing accounting standards. Others claim that restatements have risen because everyone involved in the audit process is more concerned about potential liabilities. Still others attribute the increase in restatements to a more rigorous examination of financial controls by management and auditors.

Yet there are clearly a number of restatements that had no material impact on stock prices and were generally viewed by investors as technical in nature. In such situations, the committee will look at whether it is possible to correct accounting errors prospectively, rather than through restatements of prior financials.

JofA: Given the importance of the new joint conceptual framework, do you believe FASB should consider postponing the issuance of new guidance until the new conceptual framework is complete and can be applied to its most complex standards? Why or why not?

Pozen: The new joint conceptual framework is important and should provide a consistent foundation for the adoption of specific standards. However, it would seem impractical to halt the issuance of all new guidance until the new conceptual framework can be completed, which could take several years.

A better approach may be to postpone the issuance of certain standards that would be most heavily impacted by the new framework, while allowing the issuance of other types of guidance to go forward. This choice should also be influenced by the degree to which new guidance on a particular set of issues is needed in the commercial markets.

JofA: Does the current mixed attribute system, which uses both historical cost and fair value, contribute to the complexity of the system? Do you think that the move toward more fair value measures will reduce complexity?

Pozen: The current mixed attribute system does contribute to complexity by using both historical cost and fair value methods. The rules for when fair value may or must be utilized have been the source of considerable misinterpretation and potential for gaming. And investors may be confused by an income statement combining realized and unrealized gains.

Yet it is probably not desirable or feasible to move totally to a fair value approach or to stay totally on historic cost. We will be looking for ways to clarify the rules on the use of fair value. In addition, we will consider better disclosure to investors about the assumptions underlying fair value estimates and the qualitative differences among income components.

JofA: How do you think technology such as XBRL might be used to reduce complexity and make financial reporting more useful?

Pozen: XBRL is a technology that involves tagging of specific items of information, including those in financial reports of public companies. For example, XBRL would allow investors to obtain a comparative array of selected items for all companies in an industry, such as the ratio of research spending to gross revenues. Thus, XBRL should provide financial information from SEC reports in a more useful format for sophisticated investors.

On the other hand, XBRL may be less helpful with regard to “softer” information items, like those in the management discussion and analysis. Such information items tend to be less standardized among companies and, therefore, are less amenable to comparative analysis through XBRL.

JofA: How do you envision the financial reporting model would include nonfinancial indicators such as key performance indicators and other Enhanced Business Reporting measures?

Pozen: The committee will be looking at how public companies and investors communicate with respect to non-GAAP measures of financial performance. In this effort, the committee will review the development of key performance indicators and Enhanced Business Reporting measures. Many of these indicators and measures go beyond information items in SEC filings.

At present, much of this type of communication between public companies and investors occurs in press releases that accompany the filing of a 10-K or 10-Q with the SEC. The committee will seek to understand the role of press releases and how they might be incorporated into the financial reporting system.