The Financial Executives International convened its annual conference on Current Issues in Financial Reporting last week at the New York Hilton, bringing together financial statement preparers and users, standard setters, rule makers, and academics to update and debate the emerging trends in corporate financial reporting.

Lattice vs. Black-Scholes

Spieler

As companies implement new accounting rules that require stock options to be expensed from earnings, the real challenge in establishing a value for those options is projecting the life span, says David Spieler, managing director of Duff & Phelps, because few companies have the historical data necessary to project it reliably.

Companies often ask for a lot of “what if” scenarios for calculating the options values, Spieler said—meaning if the assumption is changed upward or downward for expected life or any of the other numerous assumptions that are made to set a value, what will happen to the value figure ultimately?

Although most companies tend to prefer the simplicity of the Black-Scholes method of valuing options, Spieler said the uncertainty about expected life might give companies an incentive to consider a more complex method such as a binomial lattice model. “If we drag ourselves through the process of using a lattice model, we might find that the implied life of the option is a lot shorter,” he said, creating a more earnings-friendly valuation figure.

Munter

Paul Munter, a partner with KPMG, echoed Johnson’s remark that he’s seeing companies attach more market conditions to their option awards, which will preclude the use of the Black-Scholes method.

According to Johnson, companies are indeed beginning to consider shifting vesting terms from service time to some kind of performance metric or market condition, whether it be individual performance, business unit performance, overall corporate performance, stock price targets, total return, or another metric. In the United Kingdom, he added, performance measures for vesting are the norm and are becoming more demanding. As U.S. companies consider such a direction, they’ll be forced to use more complex binomial lattice models because the Black-Scholes model won’t accommodate such variables, he said.

But Katherine Zirolli, director of SEC Reporting & Accounting Policy at Aetna, said even with the insurance giant’s actuarial resources, it determined the added effort associated with using a binomial lattice model did not produce a commensurate benefit in providing a better valuation figure.

Allan Cohen, executive director of external financial reporting and accounting policy at Time Warner, also said his company was sticking with the Black-Scholes model, but with some variations to suit its own needs. “It’s Black-Scholes on steroids,” he said.

Pensions, Executive Compensation

Representatives of the Financial Accounting Standards Board and the Securities and Exchange Commission said compensation and retirement benefits represent a significant area for future rulemaking activity, but offered little new foresight into the scope of rule change that lies ahead.

FASB announced only a week earlier it would add a new, comprehensive project to its agenda to explore pension accounting, with a short-term goal of elevating pension liabilities from footnote disclosure to balance sheet (see related coverage at right). The longer-term goal is to examine how to best recognize and disclose the various factors that impact pension and other post-retirement benefit costs.

Herz

Robert Herz, chairman of the Financial Accounting Standards Board, said the Board will look at smoothing, or the practice of adjusting figures to reduce volatility, along with disclosures about lump-sum provisions and discount rates as areas for improvement.

Carol Stacey, chief accountant with the SEC’s Division of Corporation Finance, said SEC officials have studied the recent enforcement actions related to executive compensation, including General Electric, Walt Disney and Tyson Foods, to determine where rule changes may be in order. She said the SEC is looking at perks, retirement benefits and deferred compensation, total compensation, named executive officers, director compensation, compensation committee reports, and related-party disclosures as issues to explore.

Complexity & Judgment

“We have an extraordinarily complex reporting system,” Herz said. “It’s the most complex system in the world. Some see that as a positive, but I think it’s gotten to the point where our accounting is becoming a negative. We’ve created our own little monster here—maybe not even little.”

Herz said the complexity arises at least in part from the constant demands from the preparer community for detailed guidance. “We need you to exercise judgment,” he said. “That’s something we don’t see in abundance right now, but we need your cooperation on that.”

James Barge, senior vice president and controller for Time Warner, said the continual call for interpretation is to be expected as preparers are coping with complex rules and numerous challenges to their work. “The enforcement environment is here to stay,” he said.

Herz said he sees the Board’s current project on financial reporting—where FASB is working with the International Accounting Standards Board to examine how companies should best report their financial results—is the most important on its agenda. A completely new approach to reporting would enable rulemakers and preparer to get past a lot of the troubling issued associated with the current system, he said.

Scott Taub, acting chief accountant for the SEC, said he agrees accounting has become too complex and the SEC is highly supportive of FASB’s efforts to rewrite the reporting system.

He offered some advice on how preparers can improve reporting immediately, without awaiting rule changes:

Communicate in plain English language;

Disclose anything that will help investors better understand performance, even if it’s not required;

Consider a direct method of cash flow reporting; and

Avoid boilerplate language in management discussion and analysis, instead describing the real drivers of decision-making from management’s perspective.

Dobbs

Interestingly, accounting complexity was reflected in the keynote address of CNN anchor Lou Dobbs, whose unscripted remarks raised eyebrows among speakers and attendees. Dobbs ruffled some feathers at the event when he pressed that the Enron collapse occurred despite Enron’s adherence to generally accepted accounting principles.

Herz later set the record straight when he said from the podium that Enron’s accounting was not consistent with GAAP. A handful of conference attendees later said they were offended by Dobbs’ remarks. The mere notion that Enron followed GAAP makes the finance profession look bad, one attendees told Compliance Week. “If you start with the assumption that Enron followed GAAP, you might see why the accounting rules needed to be changed,” she said.

Fair Value

While the trend toward more fair value measurements in accounting is clear, standard setters, preparers and users of financial reports continue to debate where it makes sense and where it doesn’t.

FASB issued in October a working draft of its proposed standard defining fair value, describing how it should be measured in the various places throughout accounting literature where it’s already specified. Supporters of fair value say it gives investors more current information about a company’s assets and liabilities; opponents say it’s too complex to measure and based on too many assumptions.

Gregory Jonas, managing director for Moody’s Investor Services, said investors like fair value measurements for securities, derivatives and stock compensation as they’ve been adopted. But he questioned how much further fair value measurement should creep into the reporting process. “We need to be open about fair value, but not so open that our brains fall out,” said Jonas.

“Standard setters need to recognize that everything at fair value may be too complex,” said Colleen Cunningham, president of FEI, during her brief opening remarks.

“Our investors are interested in cash flow, not fair value,” said Richard Brounstein, executive vice president of finance and CFO for Calypte Biomedical Corp.

Seidman

Leslie Seidman, a member of FASB, said the Board will focus on the selection of the right measurement approach for items throughout financial reporting as part of its conceptual framework project. “It will be a lively debate,” she said.

Auditor Communications

The preparer community is still concerned that new audit standards and the audit oversight process have driven a wedge between companies and their auditors, restricting the consultation that used to be part of the process of issuing financial reports.

“There’s still a lot of sentiment that people are afraid to talk to their auditors, that anything they say can become a material weakness against them,” said Richard Brounstein, executive vice president of finance and CFO for Calypte Biomedical Corp. “It’s like talking to the IRS.”

The audit community is still walking a tightrope, trying to strike the right balance between meeting new audit standards, yet not being excessive in their demands for evidence, said Robert Kueppers, deputy CEO for Deloitte & Touche. “One person’s over-auditing is another person’s sufficient evidential matter,” he said.

Related resources for each topic, above, can be found in the boxes at the left of each section.

Topics