FASB Calls for a Cultural Change

Executives who use accounting-motivated transactions to prop up financial results are among the obstacles to a principles-based approach, says Robert Herz, the board's chairman.

The Financial Accounting Standards Board is conceding that its push for a principles-based accounting system could run smack into some powerfully entrenched interests.

FASB laid out the challenges it faces in a February 16 reply to a Securities and Exchange Commission report on improving the transparency of off-balance-sheet arrangements, which was issued eight months ago. Largely agreeing with the SEC, the board threw down the gauntlet against complexity, essentially calling for the U.S. accounting industry to move away from its traditional rules-based model to a more principles-based system.

In its letter, FASB agreed to revisit everything the SEC suggested: the accounting treatment of leases, defined-benefit pensions, and financial instruments, as well as consolidation policies. But the standards board also issued a broader critique, noting that form was surpassing function in financial reporting and that complexity was clouding transparency.

The response, however, reiterated the obstacles to change that FASB chairman Robert Herz hit on in a December speech to the American Institute of Certified Public Accountants (AICPA). “Fundamental structural, institutional, cultural, and behavioral forces have caused, and continue to cause, complexity in the system and impede transparent financial reporting,” he said then.

One of the forces is inertia, notes Jack Ciesielski of R.G. Associates Inc. and editor of the Analyst’s Accounting Observer newsletter. “People don’t want to change because the status quo is easier,” he says. Indeed, exorcising complexity from an accounting system that has added hundreds of bright-line rules and guidelines in the past 30 years won’t be easy.

For its part, FASB has already begun to systematically identify standards that need simplifying, such as those that are overly complex (like leasing and pension accounting) or those it deems outdated (using cost accounting for options valuation). Further, the board would like new standards to be more consistent with a principles-based system, and may borrow some ideas currently used by the International Accounting Standards Board.

But those efforts are a mere drop in a very big bucket. Herz acknowledged that the only way to move toward a simpler system is to get all the constituents to iron out their conflicting views. Taken together, the scope of their agendas is wide, since the stakeholders vary, and include FASB, the SEC, the Public Company Accounting Oversight Board, corporations, and auditors.

Indeed, Herz expects a good deal of pushback. In his AICPA speech, he identified some of the forces blocking the board’s anticomplexity campaign, including an excessive focus on short-term earnings and a fear of being second-guessed — and punished — by regulators.

Among the recalcitrants are executives bent on improving short-term earnings who use accounting-motivated transactions to prop up financial results, according to Herz. Other proponents of the status quo are auditors and corporate accountants who rely heavily on bright-line rules, worrying that the use of professional judgment could leave them open to shareholder litigation or regulatory reprimand.

The fear of second-guessing is especially prevalent in a post-Sarbanes-Oxley Act environment, where auditors constantly weigh “subjectivity and liability,” says attorney Matt Dyckman of Thacher Proffitt and Wood. “Sarbanes-Oxley made it a higher-stakes game,” he adds, noting that companies and auditors now take on “greater risk for participating in the capital markets.”

Herz hopes that by the end of the year, a panel representing all the constituents will be convened to address the shift to principles-based accounting. He doesn’t think the panel should work under the auspices of FASB, though, because the board already has enough on its plate. The SEC might be a better place to start, he says.

Still, hurdles remain enormous. For example, the four issues named in the SEC’s off-balance-sheet report each has a group of stakeholders rooting for the status quo, says David Sherman, professor of accounting at Northeastern University and a former accounting fellow in the SEC’s Division of Corporate Finance. For example, accounting rules related to synthetic leases and derivatives have spawned entire industries, he notes.

In the past, bright-line rules have been used as an excuse for companies to invoke stern cost-cutting measures, Sherman contends. Witness the 1993 release of SFAS 106 (Employer’s Accounting for Postretirement Benefits Other Than Pensions), which put retiree medical expenses on the balance sheet. Many companies used the fact that the expenses had to be recognized as a justification to cut retiree benefits.

Another obstacle is uncertainty, says Keith Bishop, an attorney at Buchalter Nemer and the former commissioner of corporations for the state of California. Any kind of business unknown increases costs, and bright-line standards eliminate such unknowns, he adds. So he doesn’t expect a rush to a principles-based system any time soon.

“Everyone is in favor of simplification,” muses former FASB chairman Dennis Beresford, who’s now an accounting professor at the University of Georgia. But he adds that “everyone also wants rules—just in case.” One thing FASB could do is refuse to respond to “nit-picking” requests from companies and auditors for more guidance, says Beresford.

FASB is doing just that, according to Herz. “We say no a lot,” he says, noting that the board gets daily requests from companies and auditors asking for new rules or exceptions to existing ones. One strong example of FASB’s new just-say-no policy is its refusal to give specific guidance on ownership percentages of variable-interest entities under FIN 46, which concerns the consolidation of off-balance-sheet transactions.

Overall, the shift to principles-based accounting is a behavioral issue, according to Bill Bosco, a member of the Equipment Leasing Association’s financial accounting committee. Bosco contends that the mindset of professionals preparing and using financial statements has to change before such a system is adopted. The focus, he argues, has to be on economic substance, rather than on “how to get around the rules.”

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