In December 2005, while I was acting chief accountant at the Securities and Exchange Commission, SEC Chairman Christopher Cox and I both spoke about reducing the complexity of financial reporting. We weren’t the first to mention this, and we weren’t the last, as the topic has been continually discussed in the two years since.
In my current job, at least several times a week, either I remark or my client remarks about how complicated the accounting is. The responses to the Financial Accounting Standards Board’s annual survey of constituents about its agenda contain repeated requests to simplify accounting standards. FASB, the SEC and its staff, preparers, auditors, and investors alike have been asking for requirements to be made simpler, more transparent, and easier to understand. And I would guess everybody reading this article is in favor of reducing complexity in financial reporting.
Although it took quite a while, the SEC’s Advisory Committee on Improvements to Financial Reporting, which will look at reducing complexity along with other opportunities to improve financial reporting, has started its work. Clearly, this is good news for the financial reporting community, because the efforts that have been made by FASB, the SEC, and others have not been successful enough to date. It’s not that there is a particular roadblock to reducing complexity, or a party that is opposed to it. Rather, the task is difficult because of the fact that just about every participant in the financial reporting process has acted, and continues to act, in ways that create or add to complexity in reporting.
I could give you a long list of examples of ways in which preparers, auditors, regulators, and standard setters have contributed to accounting complexity. In fact, since all the components of U.S. Generally Accepted Accounting Principles are there because somebody asked for it, I could make the argument that we have gotten exactly what we asked for. My point, then, in discussing a few recent examples of actions that have incrementally made understanding U.S. GAAP a bit more difficult is not to affix blame, but merely to explain why the problems are not that easy to fix. We have complexity because, incrementally, we do things that contribute to it because, at the time, those things seemed like the best thing to do.
No Good Deed Goes Unpunished
Let me start with the adoption of FASB Statement No 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with an opportunity to choose fair value accounting for any asset or liability, giving them a method of offsetting changes in values of assets and liabilities that is much easier than hedge accounting, while not requiring any new use of fair value. Statement 159 was entirely a preparer-driven standard. Users of financial statements do not think highly of Statement 159, but FASB felt that providing preparers with this flexibility was in the best interest of the markets because of the opportunities it gave for simplifying accounting and reporting.
However, some sought to turn the new standard to their advantage in a different way. The plan was to elect the fair value option for underwater assets (or liabilities), take the initial mark to fair value as an adjustment of beginning equity as provided in the standard, sell the assets (or pay off the liabilities), and then purchase similar securities (or enter into new borrowings) for which the fair value option would not be elected. Like magic, the loss would disappear through equity and the company would never actually be burdened with fair value accounting. Although this clearly wasn’t consistent with the principles underlying Statement 159, members of FASB’s staff and several large public accounting firms initially let investors down by deciding there was nothing they could do but accept this misuse of Statement 159.
Thankfully, many corporate controllers and CFOs, when presented with this proposal by their advisors, realized it for the sham that it was. The SEC staff eventually stepped in, and, with the help of the newly created Center for Audit Quality, communicated that using Statement 159 in this way wouldn’t be tolerated. Nonetheless, the impact of this kind of mischief is that standard setters are less willing to write principles-based standards, regulators are less willing to trust that issuers are applying standards in good faith, and investors wonder just how much insight financial reporting is truly providing. And, given that the way the SEC and the CAQ acted to stop the practice produced a fair amount of criticism, it is clear that there is significant resistance to requiring companies to look to the objectives of a standard when applying it. Finally, if this is what happens when FASB does something specifically targeted to simplify things, would it surprise anybody if the Board were reluctant to try to address complexity on its own again?
More Complexity, Please
In other instances, companies choose complex accounting when they don’t have to. I can’t argue with that when the more difficult method produces more meaningful results, as it often does when a company uses hedge accounting. But sometimes the complex method is also less transparent, forcing me to conclude that, for some companies, transparency and simplicity are not the most important financial reporting goals.
Defined benefit pension accounting is a great example. With the implementation of FASB Statement 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, the balance sheet figure is now simply the funded status of the plan—easy to explain and understand. But benefit plan sponsors fight hard to avoid an easy-to-understand income statement figure, by employing a complex series of smoothing mechanisms. If they didn’t elect to use these purely optional mechanisms, sponsors could avoid the tracking of deferred gains and losses, prior service cost, and other items; shorten footnote disclosures; and make their accounting more transparent to investors.
Companies sometimes desire an accounting treatment so much that they are willing to complicate their operations to get it. Consider the many ways in which companies try to structure their financing transactions to qualify for off-balance-sheet or equity treatment rather than reporting debt. When FASB issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities, many companies spent a lot of time and money restructuring their structured investment vehicles to avoid consolidation, as FIN 46 provided guidance that would have required sponsors to consolidate many of the structured investment vehicles that existed at that time. Today, much of that complicated structuring is again under pressure because of the fallout from the sub-prime lending crisis. And again, we see discussion of plans for more restructuring.
Similarly, companies continue to classify investments as held to maturity to avoid reporting volatility, even at the cost of limiting their operating flexibility, while others prepare to sell a complicated “financing” instrument that they hope will help them get a lower income statement hit for their employee stock options.
So while companies complain that accounting complexity is burdensome, they regularly seek out complexity when it helps them meet other accounting goals. And it is no doubt true that many issuers, while clamoring for simpler standards, would actively oppose changes that simplified things by removing options like pension smoothing and held-to-maturity classification for investments, even though investors have clearly communicated that they would favor such changes. Indeed, it is because of requests from preparers of financial statements that these options exist in the first place.
Is 1/4 Inch Really Important?
The SEC staff is aware of the problems of complexity and realizes that it needs to accept reasonable judgments in order to foster an atmosphere in the financial reporting community that will allow for greater use of principles-based accounting standards and facilitate the reduction of complexity. And I believe that the staff is committed to doing its part. That being said, many in financial reporting view the SEC staff as a prime cause of complexity. Recent examples may illustrate why.
As I mentioned earlier, Statement 158 requires, for the first time, that the net-funded status of a defined benefit pension plan be shown on the balance sheet. Many public companies erred by reporting the transition adjustment that arose upon adoption of Statement 158 on a separate line item within current-year “other comprehensive income” instead of as an adjustment to “accumulated other comprehensive income,” a line or two higher or lower on the page. By now, readers are probably thinking, “who cares?” I told a client who asked me about this that, at my billing rates, the five-minute conversation we had about the topic had cost far more than the issue was worth. As it turned out, the answer to “who cares?” was, “the SEC staff,” and that five-minute conversation was repeated countless times by many people over the next month or so. The staff initially asked companies to restate, pointing out that the presentation was in direct conflict with the standard and suggesting that arguments of immateriality were inappropriate in this situation. Eventually, after further discussion, the SEC staff did not require restatement, but asked registrants to disclose the error in their next 10-Q filing.
While companies complain that accounting complexity is burdensome, they regularly seek out complexity when it helps them meet other accounting goals.
Even though there were only a few actual restatements over this issue, it prompted many to roll their eyes at the suggestion that the SEC is interested in principles-based standards and will enforce application of standards in a way that focuses on important items. The SEC staff has, on many other occasions, been quite flexible upon the adoption of new accounting standards (for example, assumptions used during first-time application of Statement 123R, Share-Based Payment). But even if it is only every now and then that the staff takes a harsh line on the application of minor points of a new standard, that is understandably often enough to make preparers complain that they are being held to too high a standard.
When Comments Look Like Rules
In other situations, SEC comments to individual public companies appear to be very rules based, with little regard for the company’s judgment. For example:
The SEC staff does, from time to time, assert that errors that affect a line item in a segment disclosure by over 5 percent are material, despite company beliefs to the contrary.
The SEC staff has been very specific about whether changes in the value of redeemable preferred stock should affect retained earnings/accumulated deficit or paid-in-capital, despite the fact that, for accounting purposes, the difference between these captions is virtually meaningless.
Companies often go to great lengths to structure financing instruments in ways that allow equity classification rather than debt. Nonetheless, the staff has recently objected to presentation of a redeemable preferred stock as debt, despite the SEC staff’s previously well-known acceptance of presentation as debt of items that could qualify to be shown as temporary equity.
In all of these cases, and others, the issuers feel that they are being forced to reflect the SEC staff’s judgments over their own, or being held to arbitrary unwritten rules on items of dubious importance, and the auditors come away feeling like they can’t trust their knowledge and experience. As a result, accountants seek additional ways to ensure either: (1) their judgments will be accepted; or (2) all matters of judgment will be removed from the accounting literature. And so, issuers and auditors ask for more and more written guidance from FASB, the SEC, and others, slowly but inevitably adding to the complexity of U.S. GAAP.
Is it Hopeless?
So, the Advisory Committee I mentioned previously has a difficult job indeed, not because its attempts to reduce complexity will be actively opposed, but because it must find ways to change behaviors that are very much a common part of financial reporting, or at least must find ways to change how the financial reporting community reacts (or overreacts) to those behaviors. But there is reason to believe that improvements are possible.
During the time that I was Deputy Chief Accountant at the SEC, I heard many suggestions that seemed directly aimed at issues like the ones discussed in this article. For example, some have suggested an additional level of SEC staff review of financial reporting comments from a reviewer charged with thinking about things like materiality and use of judgment. Others have proposed the SEC be provided a quicker, easier way to combat the games that are played in financial reporting, so that investors aren’t forced to rely on the slow process of enforcement proceedings or standard setting. Perhaps a broader discussion of how to evaluate materiality will result in a clearer understanding of what errors are relevant to investors and what errors aren’t. And perhaps companies would feel more comfortable making accounting judgments if the SEC were to provide guidance on the kinds of things that would insulate a company from enforcement action.
I find all of these suggestions intriguing, and I’m sure the Advisory Committee will consider these and many more. No doubt, I will have the opportunity to write about various recommendations in future columns. Until then, I watch the progress of the Advisory Committee on Improvements to Financial Reporting with hope and anticipation.
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