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Report: The Committee on Capital Markets Regulation

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Posted by: Jack Ciesielski	12/1/2006 5:45 AM
Back in September, the Committee on Capital Markets Regulation was formed with promise of a report on its findings in November. On the last day of the month, they delivered. Their interim report is available at this link. I haven't read the report in its entirety yet, but I got the flavor of it from yesterday's Wall Street Journal editorial by two of the Committee's members: R. Glenn Hubbard and John L. Thornton. There are some noteworthy contradictions in it, at least in the editorial: The Committee recommends that "the SEC should define materiality quantitatively and consistently with the definition of materiality in financial reporting." In the very next sentence, the Committee is recommending that "the SEC and PCAOB should clarify and permit greater judgment as to the auditor's role in understanding and evaluating management's assessment process." What's troubling about that? Asking the SEC to define materiality "quantitatively and consistently" is like asking them to draw a line as to what's acceptable in every conceivable situation - and drawing bright lines like that would not only create many detailed rules involving multiple scenarios, it would also create structuring opportunities for transactions. Materiality as expressed in the SEC literature, Staff Accounting Bulletin No. 99, is already a principle-based concept. This excerpt pretty much summarizes the heart of that bulletin: "Materiality concerns the significance of an item to users of a registrant's financial statements. A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important. In its Statement of Financial Accounting Concepts No. 2, the FASB stated the essence of the concept of materiality as follows: The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws..." The Committee proposes that "consistent with the objective of focusing control review on higher-risk components of financial processes, the SEC and the PCAOB should give guidance to management and auditors to allow multiyear cycling of testing where appropriate." How does this further the cause of high quality auditing? As soon as a management is certain that auditors will forgo testing of a particular control system, the opportunity for mischief increases. Think of an outfit like WorldCom, who was unafraid to brazenly capitalize expenses. Wouldn't someone like that be emboldened by this suggestion? The Committee proposes that "small companies ... should either be subject to the same (revised) Section 404 requirements as large companies, or Congress should consider reshaping Section 404 for small companies by eliminating auditor attestation while providing for a reasonable form of certification of internal controls by management." Again, this is a proposal that has a nice sound, but it's empty. Take a look at some of the SEC's Auditing and Enforcement Releases, and you'll realize that most of the enforcement problems relate to smaller companies. So for this, they should earn Section 404 leniency? Seems like the big companies - who have implemented Section 404 without any apparent indigestion, judging by S&P 500 earnings - ought to be incensed at the inequity of such an idea. Another thing: isn't auditor attestation already "a reasonable form of certification of internal controls" from the viewpoint of the investor - a group not particularly strongly represented on the committee? The Committee proposes caps on auditor liability as a remedy for excessive litigation. Let's see: make materiality a paint-by-numbers exercise; reduce testing of some areas to a multi-year exercise; waive control-building and attestation for the companies who need it the most; and reduce legal exposure for auditors. Am I missing something here, or is this just one of the most shareholder-unfriendly political creations to come along in ages?

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