Although still in the proposal stage, there has been substantial movement by both FASB and the SEC on major issues discussed by this author in his earlier CPA Journal article “Finding the Forest Among the Trees: Overcoming Overload and Achieving Greater Disclosure Effectiveness” (July 2015, http://bit.ly/2BrI6AB). These proposals are largely consistent with the recommendations that appeared in that article, which cited the published views of many large audit firms and high-level SEC staff spokespersons and commissioners in favor of improving the clarity of SEC disclosure documents by reducing redundant, immaterial, and otherwise unnecessary disclosures and streamlining the requirements and staff communications that generated them.
The 2017 SEC Proposal
The principal recommendations in the 2015 article were for streamlining the nonfinancial statement disclosure requirements of Regulation S-K by eliminating or reducing redundant, meaningless, boilerplate, and otherwise immaterial disclosures in SEC filings.
In December 2015, President Obama signed into law the Fixing America’s Surface Transportation (FAST) Act (P.L. 114-94), affecting many federal transportation programs but primarily providing long-term funding for surface transportation infrastructure planning and investment. Buried in section 72003 of the FAST Act, however, was a requirement that the SEC to carry out a study, in consultation with interested parties, of the disclosure provisions of Regulation S-K to determine how best to modernize and simplify them, evaluate methods of information delivery and presentation that discourage repetition and disclosure of immaterial information, and issue a report of its findings and recommendations to Congress.
In October 2017, the SEC proposed rule amendments (Releases 33-10425 and 34-81851, jointly titled FAST Act Modernization and Simplification of Regulation S-K) based on the recommendations made in its staff’s report issued pursuant to section 72003 of the FAST Act. Although significant, this proposal is only a first step toward modernizing and streamlining these disclosure documents. If adopted substantially as proposed, these changes would better enable and encourage users to access information through use of modern technology and to meet Regulation S-K disclosure requirements without burdensome redundancies through extensive use of cross-references (e.g., internal hyperlinks) to information disclosed in the financial statements. Other benefits include improved clarity, readability, understandability, and efficiency of preparation and review of filings (in terms of reduced costs and time elapsed).
The SEC’s proposal would also allow issuers to omit from management’s discussion and analysis (MD&A) a comparison of operations to those of the prior year for the earliest of three years presented (when applicable) if such comparison has been included in an issuer’s earlier filing that is available on Edgar and if the omitted information is judged by management to be immaterial to an understanding of the issuer’s financial condition, results of operations, and cash flows. Some commentators (including this author) have expressed the view that this materiality evaluation requirement should be removed in the final rule amendment, since the omitted information would be readily available online in a prior filing and because basing this exemption on a subjective materiality evaluation would inherently be subject to second-guessing by both auditors and regulators. Because of a tendency to err on the side of caution, many issuers and their legal counsel would likely be discouraged from availing themselves of the opportunity to omit this redundant information and therefore cause excessive disclosures.
The 2015 FASB Proposals
The second major thrust of the 2015 article was to advocate revisions to the many unfortunate implications of FASB’s Accountings Standards Codification (ASC), which suggest that certain disclosures are “required” without regard to materiality, thus appearing to leave little or no room for issuer discretion and resulting in disclosures that are likely of no value to investors or other users in making decisions. These implications directly contradict the overriding caveat in ASC Topic 105, “Generally Accepted Accounting Principles,” that provisions of the ASC need not be applied to immaterial items.
In September 2015, as part of its ongoing disclosure framework project, FASB released two related proposals for public comment about applying materiality evaluations to determine whether disclosures are necessary. The first of these proposals was to amend Chapter 3 of Statement of Financial Accounting Concepts 8 (SFAC 8), Conceptual Framework for Financial Reporting to eliminate an inconsistency in FASB’s definition of “materiality” with those of other authoritative sources, principally a U.S. Supreme Court decision. The root of the inconsistency lies in whether an error or omission “could” or “would” likely influence the decisions of a user—that is, the difference between possible and probable. To resolve the inconsistency, FASB initially proposed to deny that materiality was an accounting concept and instead assert that it was a legal concept (thus deferring to the Supreme Court definition, which uses “would”).
The second proposal was to amend ASC Topic 235, “Notes to Financial Statements,” to promote the appropriate use of management discretion in deciding which disclosures under consideration should be viewed as material. To overcome any erroneous implication that certain disclosures are required without regard to materiality, the amended Topic 235, if adopted, would expressly state that an omission of immaterial information is not an accounting error.
Based at least in part on the arguments presented in the 2015 article, one might likely conclude, as did FASB, that these proposals would not be controversial. One would be wrong. Investor groups rose up against both of these proposals, suggesting that the proposed changes will necessarily result in less disclosure. According a January 2, 2016, New York Times article by Gretchen Morgenson (“FASB Proposes to Curb What Companies Must Disclose,” http://nyti.ms/2BWKMal), “few investors seem to agree that financial filings today contain a flood of irrelevant information.” But as should be evident from this author’s 2015 article, almost everyone else involved in the financial reporting world thinks they do.
Morgenson further cites a comment letter written to the FASB by a CEO of an investment firm as follows:
While the proposed changes on definitions [sic] of “materiality” are written as if they are minor technical reforms designed to reduce the inclusion of marginally useful information in corporate filings, we feel in reality they are misdirected, and send an entirely wrong message to the corporate community—that less disclosure is better—when in fact, the opposite is true.
Clearly these investors do not understand that a FASB concepts statement merely provides guidance to FASB in drafting its standards; it is not in itself GAAP. The SFAC 8 definition of “materiality,” therefore, does not govern how the concept of materiality is applied, and has almost never been referred to by auditors to guide their evaluations of clients’ materiality judgments regarding their financial statements or related disclosures. Auditors, who are the first arbiters of management’s materiality judgments, are governed in their evaluations by the definitions in the auditing standards, which in the case of public issuers are those of the PCAOB. Not coincidentally, however, the definition in the PCAOB standards (AS2105.02 and 2810.B1) is based on, and closely aligned with, the Supreme Court’s definition and not FASB’s. On the other hand, the Auditing Standards Board’s current definition (AU-C 320.02), applicable only to audits of financial statements of private companies, uses the expression “could reasonably be expected to influence” (emphasis added) and therefore more closely approaches FASB’s current definition, although this may soon change.
At its meeting on November 10, 2017, FASB decided to withdraw its proposed references that would have characterized materiality as a “legal concept” and to amend the definition thereof by reverting to language similar to the superseded definition in SFAC 2, Qualitative Characteristics of Accounting Information. As with the Supreme Court, the older SFAC 2 definition uses the term “would” rather than “could” and therefore more closely tracks and eliminates conflicts with the Court, the PCAOB, and the SEC’s definitions. [The latter is based on Rules 12b-2 and 405, respectively, of the 1933 and 1934 Securities Acts, which say the term applies to “those matters to which there is a substantial likelihood a reasonable investor would attach importance in determining whether to buy or sell the securities registered” (emphasis added).]
FASB will continue to deliberate the proposed amendments to ASC Topic 235 to remove the unfortunate and erroneous implications that currently appear throughout its standards that certain disclosure “requirements” apply without regard to materiality considerations. Hopefully, wisdom will prevail here as well.
