Are Current Financial Accounting Standards Protecting Investors?
by Robert K. Herdman
Chief Accountant, U.S. Securities and Exchange Commission
Before the Subcommittee on Commerce, Trade and Consumer Protection,
Committee on Energy and Commerce, U.S. House of Representatives
February 14, 2002
Chairman Stearns, Ranking Member Towns, and members of the Subcommittee:
I am pleased to appear before you on behalf of the Securities and Exchange Commission ("SEC" or "Commission") to testify on the importance of responsive and transparent financial reporting to investors and our capital markets. The specific question this panel was asked to address is "Are current financial accounting standards protecting investors?"
Our financial reporting system has long been considered the best in the world and is one of the underpinnings of our capital markets, which are the deepest and most liquid in the world. However, certain aspects of the system can and should be improved so changes to accounting standards can be implemented more quickly, be more responsive to market changes, and provide more transparent information to investors. Our current system's weaknesses are more visible as a result of Enron's failure.1 However, these weaknesses did not arise overnight, rather they evolved over many years. Investors expect our system to be the finest in the world. We intend to see that it remains the finest. Today I will discuss what should be done.
Concerns about our financial reporting system precede the bankruptcy of Enron Corporation and my testimony reflects that. The Commission is investigating events associated with Enron's collapse; and, consistent with the Commission's rules and practice, I am unable to discuss the specifics of that ongoing investigation. The Commission requests that the Subcommittee respect the confidential nature of the Commission's investigation and our reluctance to address specific issues related to Enron's compliance with federal securities laws in this public forum.
Overview of US Standard-Setting Process
The SEC relies on an independent, private sector standards-setting process that is thorough, open, and deliberate. While the Commission has the statutory authority to set accounting principles,2 for over 60 years it has looked to the private sector for leadership in establishing and improving accounting standards.3 The quality of our accounting standards and our capital markets can be attributed in large part to the private sector standards-setting process, as overseen by the SEC.
The primary private sector standards-setter is the Financial Accounting Standards Board (the "FASB"), which was established in 1972. An oversight body appoints the members of the FASB. This oversight body, the Financial Accounting Foundation, is comprised of investors, business people, and accountants. The FASB's standards are designated as the primary level of generally accepted accounting principles ("GAAP"), which is the framework for accounting. The FASB's standards set forth recognition, measurement, and disclosure principles to be used in preparing financial statements.
The secondary standard setter is the Accounting Standards Executive Committee (AcSEC), which provides guidance in the form of Statements of Position (SOPs), subject to the affirmative concurrence by the FASB at every step in the process. The principal purpose of AcSEC, which is a committee of the American Institute of Certified Public Accountants (AICPA), is to develop standards for specialized industries.
The interpretative body of the FASB is the Emerging Issues Task Force (EITF). It meets every other month to provide interpretative guidance, or develop new guidance, on narrow, new or emerging issues that arise under existing GAAP and when GAAP does not exist.
Criticisms of U.S. Accounting Standards and Standard Setting
Even before Enron's collapse, we called upon the FASB to work with us to address concerns about timeliness, transparency, and complexity. Specifically, we asked the FASB to address criticisms that:
- The current standard-setting process is too cumbersome and slow.
- Much of the recent FASB guidance is rule based and focuses on a check-the-box mentality that inhibits transparency.
- Much of the recent FASB guidance is too complex.
Recently, some people have suggested that the FASB should be federalized instead of remaining in the private sector. Those who suggest this apparently have lost confidence in the FASB's process. There is no assurance that simply placing the structure within the federal government would result in better accounting standards. For example, many question whether the FASB's proposal to expense stock compensation, before the Congress intervened, would have been better for investors.
Federalization of the FASB not only would require increases to the federal budget, but also might disenfranchise those who are best qualified to address the highly complex business and accounting issues that must be resolved. I believe that with the Commission's leadership and cooperation by the FASB, the FASB can be effective, and confidence in the process can be restored. Private-sector standard setting can work in our current business environment, even as financial transactions become more complex. In spite of recent events, we still have the best financial reporting system in the world, and the Commission is intent on making it even better.
When done properly, standard setting in the private sector is the best alternative for our capital markets as it provides a number of advantages over federalized standard setting. Private sector standard setting has greater flexibility to complete rules more quickly than accounting standards set by the government. The FASB is comprised almost entirely of accounting experts and has a greater ability to attract and retain qualified personnel. Similarly, AcSEC and the EITF are composed of members with accounting expertise.
Evolution of Standard Setting
It is important to understand how the current system of standard setting evolved. As we contemplate reform, we need to consider how we got here. In the late 1970s and early 1980s, the FASB undertook a series of projects to drastically change how financial information is reported to investors and other financial users. These projects, which include consolidation of financial statements and accounting for financial instruments, represent major conceptual changes in financial reporting. As you might expect, such sweeping change has been very controversial and sapped the resources of the FASB.
As a result, issues such as revenue recognition (which is a factor in approximately one-half of all restatements and financial reporting enforcement cases) and consolidation of SPEs have not been adequately addressed by the FASB. The EITF and the SEC staff have attempted to address some of the issues, but without an underlying principle the result has been disappointing.
In other cases, the FASB has delegated broad issues such as accounting for partnerships; property, plant and equipment; and the accounting for environmental liabilities to AcSEC. AcSEC is comprised of part-time volunteers from the preparer, auditor, and user communities and is subject to affirmative review by the FASB each step of the way. As a result, AcSEC is ill equipped to deal with broad issues in a timely manner. While AcSEC's guidance has been of high quality, it often takes years to issue because of its infrastructure constraints.
Another criticism that has arisen over time is the trend to complex, rule-based accounting standards. This trend can be attributed to a number of factors including (1) changes in how companies do business; (2) granting exceptions to new controversial standards; (3) internal conflicts in the accounting literature as the conceptual underpinnings change; and (4) demands for a single answer to every question. FASB Statement No. 133 on accounting for derivatives and hedging and Statement No. 140 on transfers of financial assets and extinguishments of financial liabilities are two prominent standards that have been subject to such criticism.
Now I would like to review with the Subcommittee actions that should be taken to continue to ensure that our financial reporting system remains the premier system in the world. Let's begin with the FASB. The FASB must change the scope of many of its technical projects and the manner in which it carries out its activities.
The FASB uses a building-block approach when developing standards. That is, the Board addresses a handful of issues at any given meeting instead of all of the issues that comprise a single proposal. This approach tends to expand the time it takes to resolve reporting issues. In contrast, the SEC staff generally will present an entire proposal to the Commission for consideration. The FASB needs to reconsider its approach.
The Board's major projects tend to be very broad. For example, the FASB currently has on its agenda a liabilities and equity project that raises six or seven important issues. I believe this project has too broad a scope. It attempts to weave too many issues into a conceptual framework everyone can agree on. Most people agree that more guidance is needed on equity derivatives and redeemable preferred stock. Why not separate out these issues and provide timely guidance on them? The remaining issues, where many believe no additional guidance is necessary, can be addressed at later dates. Narrowing the scope to its critical elements allows the process to move forward in a timely manner.
Some are calling for a limitation on the time a project can be on the FASB's agenda. I share their concerns about timeliness. It is clear that the FASB must work more quickly and be more responsive to market needs. For example, how it deals with the issue of when to consolidate SPEs is important. This project must be finished so it can be both effective for, and implemented by, the end of this year. If the FASB is not able to make progress on such important issues as they arise, the SEC should take action. We must improve our oversight of the standard-setting agenda.
Principle-Based Accounting Standards
As I mentioned in my introduction, over the last few years many of the FASB standards have been rule based, as opposed to principle based. Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. Examples of rule-based accounting guidance include the accounting for derivatives, employee stock options, and leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.
An ideal accounting standard is one that is principle-based and requires financial reporting to reflect the economic substance, not the form, of the transaction. FASB Statement Nos. 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, which were issued in 2001, appear to be steps in the right direction. These standards will serve as a test of the level of specificity needed to strike a balance between rules and principles. Principle-based standards will yield a less complex financial reporting paradigm that is more responsive to emerging issues.
Furthermore, a byproduct of rule-based accounting standards has been an increase in the number of "SAS 50" letters issued to investment banks providing opinions as to whether hypothetical transactions follow accounting standards. SAS 50 letters may be used as the basis to structure complex transactions that technically comply with accounting standards, but do not accurately reflect the objectives of the standards. I believe it is in the public interest that the Auditing Standards Board ban those types of letters, and yesterday I sent a letter to the Auditing Standards Board urging that it do so.
A move to principle-based standards will require greater discipline by the corporate community, the accounting profession, private-sector standard-setting bodies, and the SEC staff. A move away from a check-the-box approach to financial reporting means that all constituencies must make concerted efforts to report transactions consistent with the objectives of the standards. While this may mean that not all transactions are recorded in exactly the same manner, it is my belief that similar transactions in this system of principle-based standards will not be reported in materially different ways, preserving comparability.
While the FASB addresses issues of timeliness, transparency and complexity it must remain nimble to deal with changes in the market. Looking ahead, it must accelerate its efforts to achieve short-term convergence with the International Accounting Standards Board and coordinate with the SEC's financial reporting and disclosure reform initiatives so our capital markets can continue to be the deepest and most liquid in the world.
Now I would like to discuss how better resource management should improve timeliness of standard setting. This is where the leadership of the SEC is important. As I stated at the outset, the FASB is subject to the oversight of the SEC.
Allow me to describe how I believe that oversight should work. In light of its enforcement and review activities, the SEC is in a unique position to provide input into the FASB's agenda. We have a responsibility to do that, and the FASB has a responsibility to address the issues we refer to them in the time frame that we request, even if it is 180 days. I believe that we can and should stay out of their way once we ask them to take on a project. However, we should meet with the FASB frequently to monitor the status of their projects. If projects are languishing, we must determine why.
Generally, there are two reasons that topics remain on FASB's agenda for extended periods. First, there may not be a problem with existing guidance, as many believe is the case with the basic consolidations model. Using resources to revisit this model slows the process and detracts from the Board's ability to address the more important issues such as SPEs.
Second, a topic may remain on the agenda for an extended period because it is too broad. This is a principal reason why the Board has had to spend much time on its liability and equity project. Instead of focusing solely on the pressing issues of accounting for redeemable preferred stock and equity derivatives, the FASB has decided to use the project to make conceptual changes to minority interest and require separate accounting for elements of certain debt instruments, delaying project completion.
The changes I have discussed in my testimony should allow the FASB time to address important issues as they arise, and eliminate the need to refer broad issues to AcSEC and the EITF, so they can focus on developing industry and interpretative guidance, respectively, as they were designed to do.
In summary, let me reiterate that we have the deepest and most liquid capital markets in the world largely because of the high quality of our financial reporting system. While it is imperative that the issues of standard-setting timeliness, transparency, and simplification of accounting standards be addressed, we should not abandon the system that has allowed us to achieve what we have to date. Instead let us take the opportunity to make fundamental changes to standard setting and SEC oversight.
1 In a Form 8-K dated November 8, 2001, Enron Corporation stated that it would restate its financial statements for the years ended December 31, 1997 through 2000 and quarters ended March 31 and June 30 2001 because it did not follow GAAP. On December 2, 2001 Enron filed for bankruptcy.
2 See, e.g., section 19(a) of the Securities Act of 1933, 15USC 77s(a), and section 13(b)(1) of the Securities Exchange Act of 1934, 15 USC 78m(b)(1).
3 Accounting Series Release (ASR) No. 4 (April 1938) and ASR No. 150 (December 1972).