The SEC's "Complexity-Killer Committee" - Part IV

A few more thoughts on the above-named committee…

They held their first meeting last Thursday; link to archived webcast here. Here’s their discussion paper. Looks fairly complete: they name many of the bad things that have contributed to complexity in financial reporting over the years. As they see it, they’ll be considering complexity on these fronts:

I. Substantive Complexity - Will principles-based standards help reduce complexity? How about reducing competing principles in reporting, like historical cost vs. fair value? How do the conflicting forces of users’ needs (more information, please - for instance, more segment info) and the preparers’ desires (divulge less, because we’d be helping competitors) contribute to complexity? Also to consider: how exceptions to standards and industry-specific standards contribute to complexity.

II. Standard Setting Process - The GAAP hierarchy includes FASB pronouncements, EITF consensuses, SEC interpretations, and other interpretations. How can this be streamlined? How can cost-benefit analysis be applied to standard setting?

III. Audit Process and Compliance - How do the PCAOB, the SEC’s Division of Corporation Finance, and the SEC’s Division of Enforcement contribute to the complexity of the audit process? What can be learned from the wave of restatements over the last few years? How can the use of judgment in the audit process reduce complexity and improve efficiency? How do audit firms contribute to complexity?

IV. Delivering Financial Information - Can information be “tiered” by investor classifications so as to make some information more summarized and “up front” in financial reports than others -with links to more detailed information? (Sorry - that sounds like a prescription to add complexity, at least for preparers and auditors.) How about tagging key performance indicators so they can be easily grouped and examined by investors?

V. International Coordination - Are their international “best practices” that can be brought to the above subsets? Are their IASB practices that the FASB might consider in its standard setting?

That’s an ambitious roster of assignments - a task worth of Hercules in the Aegean stables.

There’s one big problem they don’t address that I believe is at the heart of all complexity in financial reporting: volatility. More specifically, how preparers react to investor perceptions about the reporting of volatility results.

Because some investors shun investment in companies that have volatile profits - even if that’s the nature of their businesses - preparers will go to goofy lengths to reduce volatility. Sometimes that will include making acquisitions to decrease volatility in operating income - the old argument for diversification. And sometimes reducing volatility means finessing estimates of accruals, like bad debt reserves or depreciable lives or lease residual values, and so on, just to make a particular earnings trend that can be trotted out at analyst meetings on a PowerPoint presentation. The philosophy of many preparers seems to be to transform something that is inherently volatile into something smooth - and they ask for accounting exceptions or resist reporting progress in order to keep things “smooth.”

There’s another angle to this dread of volatility: stock-based compensation. With so many officers and employees now compensated in stock-based comp, there’s more incentive to keep earnings smooth, with all their attendant accounting complications. That’s because smooth earnings are better for managing Wall Street expectations - plus it’s something that Wall Street will like. There’s a better chance of profitable stock-based comp if you can keep earnings smooth - and Wall Street happy.

Maybe the committee should look at the reasons that volatility is so despised by investors - and find examples of where accounting has been developed to dance around it. Why not tally up the devices or mechanisms built into the accounting literature to limit volatility? Then decide whether they’re worth the bother and get the standard-setters to remove them. (Pensions and OPEBs and hedge accounting for derivatives all come to mind…)

Maybe the FASB/SEC need to drill home that making something non-volatile by using accounting is not good accounting - and that standard setters need to be supported by the SEC to be more fearless in setting rules that report financial results as they really are, not how preparers and investors would like to see them.