D.C. Gets An Earful On Financial Reporting

Some of the most influential lawmakers on Capitol Hill met with a who’s who of financial reporting last week to hear ideas about how to reduce complexity in accounting rules, how to encourage new technology for enabling interactive data, and whether it’s wise for companies to issue earnings guidance.

The House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises fielded a wide-ranging hearing on the state of financial reporting, with regulators, investor advocates and accounting industry leaders attending to share their thoughts.

Committee leaders made it clear they want ways to cut through complex rules to improve the financial reporting system. “There must be a concerted effort on the part of all market participants to move away from rules-based accounting and auditing standards to a principles-based financial reporting system,” said Rep. Michael Oxley (R-Ohio) of Sarbanes-Oxley fame, chairman of the House Financial Services Committee and overseer of last week’s event.

Oxley

Oxley praised a recent call by the U.S. Chamber of Commerce for an end to quarterly earnings guidance. “It is too tempting, once that guidance is issued, for a company to manage its business to meet those short-term earnings numbers rather than manage its business for the long-term health of the company,” Oxley said. “This may lead to poor decision making, but also sometimes to earnings manipulation.”

Oxley said he’d like to see progress in the development of extensible business reporting language (XBRL) to allow easy access to financial information. To keep regulators and rulemakers on their toes, subcommittee members introduced a bill that would require representatives of the Securities and Exchange Commission, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board to report to the update Congress annually on the progress toward reducing complexity.

Bill Gradison, acting chairman of the PCAOB, said he believes a principles-based system of accounting without rules providing at least some measure of specificity is unrealistic. “I firmly believe that a system of rules without principles is unworkable, though I expect the debate over the right balance between the two will never go away,” he said. “That debate is not only healthy and timely, it is at the heart of the issue before us: complexity, transparency, and accuracy.”

Gradison

Principles-based standards allow more flexibility and professional judgment, he said, but also lead to more variability in results. Corporate managers looking for good results may press accountants to produce evidence to “show me where the accounting standards say I can’t do this,” Gradison said. “Many accounting standards were created, or modified, in order to provide a definitive answer to that question.”

FASB Chairman Robert Herz said complex rules have grown from a variety of forces, including an emphasis on short-term earnings, transactions structured to achieve a form-over-substance result, resistance to change, and demands for detailed rules, bright lines, guidance, and exceptions driven by fear of second-guessing and litigation. He outlined a number of initiatives FASB is undertaking to try to simplify rules going forward and focus rules on accounting concepts.

EXCERPT

Below is an excerpt of testimony from Colleen Cunningham, chief executive of Finanicial Executives International:

Cunningham

Although the litigation explosion is something we urge Congress to address as described in Recommendation 3 below, there are important actions the regulators can also take to help stem the tide of litigation and the related desire for rules-based standards. Specifically, regulators need to limit second guessing of professional judgments by corporate management, particularly judgments that have been confirmed by the professional judgment of outside auditors and outside legal counsel.

In this regard, we note the detrimental effect of the “should have known” standard that is described in the recent report of the U.S. Chamber of Commerce, regarding SEC Enforcement. We share the Chamber’s concern in this regard, and believe the SEC should give serious consideration to the Chamber’s recommendations, including recommendations to reduce the undue pressure on companies to waive attorney client privilege and other pressures to “cooperate” that unduly weaken companies’ ability to do a thorough investigation and avoid harming employees unreasonably in an effort to appear to cooperate. Importantly, we also note the Chamber’s report on SEC Enforcement considered the issue of accounting complexity and second-guessing many times throughout the report. Although the Chamber’s report is directed at the SEC, we believe this substantiates the point I made earlier, that the standard setters should not ignore issues of auditability, nor should they ignore a “reasonableness” test of how their standards will be understood and applied in the real world by preparers and users of financial statements.

Although I support the SEC’s encouragement of studying the use of interactive data such as XBRL and the benefits it can provide, I urge one note of caution: that interactive data is not a “panacea” in that transparency provided through electronic links or the old fashioned way through non-linkable disclosure will not reduce the “operational” complexity imposed on preparers and auditors to develop the numbers provided in financial reports, nor will such transparency improve the understandability of the underlying numbers to investors. The PCAOB plays an important role in reducing complexity as well. And that is by avoiding unreasonable second-guessing in its inspections of audit firms, with respect to interpretations of GAAP by management, which were previously opined on by outside auditors and outside legal counsel.

To win the war on complexity, both the PCAOB and SEC will need to maintain a disciplined approach, to assist all other constituents in the financial reporting process, in reducing the “expectation gap” of the public – i.e., that information provided by financial reporting provides reasonable estimates of numbers – and that auditors' opinions provide reasonable – but not “absolute” assurance.

Source

House Financial Services Committee (March 29, 2006)

The fear of second-guessing was a major theme for Colleen Cunningham, president and CEO of Financial Executives International, as well. Regulators must be more tolerant of professional judgments, she told lawmakers, and Congress must do something to stem the rising tide of litigation. Preparers also want to see FASB apply a “concepts-first approach to accounting standards setting, followed by the principles,” she said, so that standards flow from a consistent theoretical foundation.

Cunningham blasted FASB’s continued pursuit of standards that shift accounting away from historical costing toward increased use of fair value measurements. “In terms of complexity, accuracy, and transparency of financial reporting, we are very concerned that FASB’s proposed fair value measurement standard will only exacerbate complexity, with little benefit to, or indeed may actually detract from, the understandability and usefulness of the resultant reporting information,” she told the subcommittee.

Fair value measurements are increasingly controversial because they require valuation of assets at fair market value, even in some cases where values must be estimated because no market exists to serve as a benchmark.

Hirschmann

The U.S. Chamber also took shots at the continued march toward fair value. “While the push toward fair value auditing may be theoretically pure, the costs may end up being much greater than the benefits,” said David Hirschmann, senior vice president of the Chamber. “There are, no doubt, limitless things that could be both estimated and added to financial statements. And many of them would be consistent with Generally Accepted Accounting Principles. However, we can’t lose sight of the fact that they are estimates. The move toward fair value accounting should be tempered by a thorough examination of the implications to both business and investors of adding another imprecise estimate to the financial statements.”

Defenders of fair value, however, say increased use of fair value to measure financial instruments would cut through the complexity of hedge accounting rules, described by some as the most complex area of GAAP. “If most or all items in the statements are measured at fair value, one significant source of complexity in financial reporting would be removed: that which derives from the mixture of both historical cost and fair value measurement in the same statements,” said Rebecca McEnally, director of the Capital Markets Policy Group for the CFA Institute.

Hirschmann also blasted the practice of earnings guidance, saying companies should instead better communicate their strategies and objectives and devise alternative benchmarks that demonstrate progress toward reaching goals. But SEC’s enforcement of fair disclosure regulations, he said, has served to restrict communication. Hirschmann called on the SEC to re-examine Regulation Fair Disclosure to help the market move away from earnings guidance.

Scott Taub, acting chief accountant of the SEC, said for its part the agency wants to emphasize data tagging technology—XBRL—to give investors better access and ability to compare data across companies. The reporting technology has become a pet project for SEC Chairman Christopher Cox, though so far only a handful of companies have signed on to the pilot reporting program.

Projects that simplify financial reporting and make financial information more user-friendly have the long-term potential to benefit investors and companies alike, Taub said. “The Commission, FASB and PCAOB, however, cannot fulfill that potential without the assistance of, and input from, investors, members of managements and audit committees, accountants, lawyers, analysts and the other participants in the American securities markets.”