A Simpler Way to Set Standards

The creation of a high-profile committee to examine ways to simplify the rules for financial reporting could breathe new life into a related debate: how to simplify the creation of those rules in the first place.

Amid much fanfare, the Securities and Exchange Commission appointed a new Committee to Improve Financial Reporting in June. Its mandate is to study the causes of complexity, and recommend “how to make financial reports clearer and more beneficial to investors, reduce costs and unnecessary burdens for preparers, and better utilize advances in technology to enhance all aspects of financial reporting,” according to SEC statements.

One topic the advisory committee plans to tackle is the maze of rules and guidance issued by regulators, rulemakers, and industry groups, intended to help companies understand financial reporting but just as often leaving them confused. Robert Pozen, head of MFS Investment Management and chairman of the committee, describes it as “a proliferation of pseudo-GAAP [Generally Accepted Accounting Principles]” which companies then take as gospel.

“We can’t change everything that’s been done in the last 50 years, but maybe going forward we can start the process in a different direction,” he says.

Pozen

Pozen says companies need a better roadmap of where to go for guidance on implementing standards. For instance, he asks, when a company has a general question about an accounting principle, should it go to the SEC’s Office of the Chief Accountant, its Division of Corporation Finance, or the Financial Accounting Standards Board?

“These are some of the process issues we need to clarify,” Pozen says. He does not advocate eliminating all informal guidance, but says “we ought to confine GAAP to a narrow group.”

Pozen also says a better balance must be struck between broad principles and detailed rules. “I think one reasonable objective is that, whenever we put out a standard, we ought to have a very articulate set of principles from which the rules lead,” he says. “That may allow us not to have such detailed rules or to not have rules in certain areas.”

Pozen notes that greater reliance on principles requires accepting a level of judgment and discretion on the part of management and auditors—something “people have to come to grips with,” he stresses.

Critics of GAAP complexity fault fear of litigation as one culprit; auditors, worried about being sued if a client’s financial statements later turn out to be wrong, pepper regulators with questions to clarify some point, leading to more and more rules. The advisory committee can’t change the U.S. legal system, Pozen admits, but “we can hopefully encourage the [Public Company Accounting Oversight Board] to provide a procedural framework for its inspections and its review of audit work on the question of judgment.”

The rising number of restatements—already the subject of an analysis by the Treasury Department—is also on the committee’s radar. “The notion of what’s really material for restatements has changed over the years,” Pozen says. “I think one of the things we’re going to have to do as a committee is understand the variety of reasons for restatements, and then try to figure out how we can essentially sort out those things that really should be restatements from the things that … we can correct through other means.”

STANDARD THOUGHTS

Below is an excerpt of the Financial Reporting Advisory Committee’s discussion paper, examining the role of the Financial Accounting Standards Board in setting financial reporting rules.

FASB has an open due process through which the Board obtains input from many constituents, issues proposals and receives extensive further input in the format of comment letters, and holds public meetings with constituents. The Board makes all decisions on its accounting standards in public through open debate prior to reaching conclusion. This process can take many years, but was designed to provide constituents maximum input into the decisions of the Board. Currently, a simple majority vote is needed to complete projects. The Board publishes all decisions via board minutes on its Web site and as a basis for conclusions within all significant standards.

FASB develops major standards based on a conceptual framework. This conceptual framework was designed by previous Boards to act as fundamentals on which future financial accounting and reporting would be based. The conceptual framework, however, is not complete and is not consistent with all of existing U.S. GAAP. To address these issues, FASB currently has a major project on its agenda jointly with the International Accounting Standards Board (IASB) to improve the conceptual framework and to readdress some major accounting standards where the application is not consistent with the conceptual framework or does not provide sufficiently transparent financial reporting. Areas being considered in this joint project include pensions, leasing, liabilities and equity, revenue recognition, and financial statement presentation.

Accounting standards resulting from FASB’s process often leave open many questions of interpretation. The underlying reason for the need for interpretation generally results from either a misunderstanding of the stated principle or rule or a concern that others will express a different view of the application of the principle or rule within the standard. FASB’s staff offers a service to respond to inquiries, but exercises caution in answering some inquiries due to the establishment of precedent. Sometimes FASB or the staff are asked to formally amplify or clarify a set of interpretive issues within an accounting standard. These interpretations were previously published as FASB staff question and answer documents with little Board oversight and no public comment period. Currently, these interpretations are primarily done through FSPs (FASB staff positions), which are discussed and debated with Board members at a public meeting and exposed for comment.

The subcommittee may wish to consider the process for setting standards and developing interpretations, including FASB’s voting procedures and the methods used by FASB or FASB staff to: (1) set their agenda, (2) set their priorities, (3) deliberate, (4) communicate, and (5) respond to technical inquiries.

Source

SEC (July 31, 2007)

Since its first public meeting on Aug. 2, the committee has formed four working groups to look at substantive complexity, the standards-setting process, compliance and audit practices, and information delivery. The group also wants to examine international coordination, but is postponing action on that front until it reviews comments on SEC plans to allow companies to file statements either in U.S. GAAP or International Financial Reporting Standards.

“We need to think about whether that promotes complexity or reduces complexity and whether it’s really useful to investors or not,” he says. Comments on the SEC’s two plans—a rule proposal for foreign companies, and a concept release for domestic filers—won’t be available until mid-November.

The committee’s next open meeting is slated for Nov. 2. Another will follow in January, and Pozen hopes the panel will issue some interim proposals then. The group’s final report is due next summer.

Needing a Fix?

Ciesielski

Others agree changes are needed to improve the quality of financial reporting, but views on the root causes of complexity and possible solutions vary. Jack Ciesielski, owner of investment research firm R.G. Associates and publisher of Analyst’s Accounting Observer, says efforts to reduce volatility are a major cause of complexity in financial reporting. Until the business community “grows up and faces volatility in financial reporting,” he says, “we’re not going to solve the complexity problem. It will just grow back. People will go right back to asking for exceptions.”

Likewise, former FASB member Paul Miller, an accounting professor at the University of Colorado at Colorado Springs, says the quality of information produced under GAAP is “very low, simply because so much of it is rooted in the past and artificially smoothed.”

Miller wants to see major reform, but he’s skeptical that the committee’s efforts will produce meaningful change.

Miller

A discussion paper circulated after the committee’s first meeting, and previous statements from some committee members, “cause me to expect the final report to propose ‘changes’ that will not just preserve the status quo, but move it deeper into the flaws of the past,” Miller says. “I sincerely hope I’m surprised, but I think this effort is ill-fated from the beginning, just like the efforts of other groups who produced reports that have done nothing but gather dust.”

Lynn Turner, former chief accountant at the SEC, notes that investors don’t have much representation on the panel. Of its 17 members, only one, Motley Fool Senior Investment Analyst William Mann, is designated as representing individual investors. FASB and its Emerging Issues Task Force also lack enough investor representatives for those constituents to be able to veto any standards.

Turner says Pozen’s committee should get input from investor advocates such as the CFA Institute and the Council of Institutional Investors. “That would be a good starting point,” he says.

An even larger problem, say Turner and Miller, is the standards-setting process, which both say is political—resulting in, according to Turner, “a lot of compromises and a lot of exceptions” to fundamental principles that add “a tremendous amount of complexity.”

“They need to figure out how to change the standards-setting process so that it develops a product that users—investors—would give a high grade on, and to produce numbers that more accurately reflect [the] economics of what’s going on in the business,” Turner adds.

He suggests that every accounting standard developed “should lay out up front, in plain English, the top five objectives the standard is trying to achieve.”

And ultimately, one of the primary reasons financial reporting has grown so complex, Turner says, is that business itself has. “Business is exponentially more complex today than it was two or three decades ago,” he says. “It’s tough to understand why people think accounting—which is supposed to reflect the economics of the business—should be ‘simple.’”