The move to a principles-based accounting system is likely to demand that corporate finance executives be good yarn-spinners, speakers at the annual CFO Rising conference said.
A system less like the rules-based U.S. generally accepted accounting principles (GAAP) and more like the judgment-focused international financial reporting standards (IFRS) would draw more heavily on the narrative skills of finance executives, according to David Sherman, a professor of accounting at Northeastern University. A good story, elaborated from solid principles, would be hard for an independent auditor to challenge under such a system, he suggested.
Speaking last week at a panel on the future of accounting regulation, Sherman noted, however, that under the more principles-based system envisioned under the Securities and Exchange Commission’s roadmap for global convergence of accounting rules, the footnotes to financial statements will necessarily expand to fill in the details formerly supplied under U.S. GAAP. “It means you get a lot more clarity,” he added, but also a lot more board involvement in approving those details.
But U.S. companies are a long way from having a solid foundation on which to base their stories. For example, unlike IFRS, U.S. GAAP has no single “conceptual framework” — a basis from which future accounting standards can be built. Currently, a company preparing financial statements under IFRS must consider the International Accounting Standards Board (IASB) framework when there’s no standard or interpretation that specifically applies to an action the company is taking.
There’s no similar requirement under U.S. GAAP. The Financial Accounting Standards Board’s concepts statements, which are used when there are no applicable standards or interpretations, wield the same authority as accounting textbooks, handbooks, and articles. Further, the concepts statements have “a lower authoritative status than practices that are widely recognized and prevalent either generally or in the industry,” according to a FASB document.
The absence of a conceptual framework means that U.S. issuers would be hamstrung in complying with a principles-based reporting system. “If you’re going to use a story line, you have to get very conceptual,” said another panelist, John Hepp, a Grant Thornton partner.
Hepp said he’s amazed at how many preparers that report in IFRS will propose using accounting methods that IASB already has explicitly rejected. Hepp stressed how important it is that accounting standard setters explain the basis for their conclusions when writing standards, because that allows auditors to explain to clients why certain methods are not acceptable.
Indeed, IASB has actually become more rigorous in terms of spelling out the reasons for its decisions. The members of the international board are “even amending [their explanations] now when they change their mind[s] about why they have made a particular decision,” Hepp said, “which we think is just excellent.”
In fact, he said, his firm was “very disappointed” in FASB’s decision late last year to leave the basis for conclusions out of the July 1 codification of the board’s standards “because that makes our job much harder.”
To be sure, rapid adoption of IFRS in the United States would mean hefty revenues for audit firms like Grant Thornton. Nonetheless, Hepp said, he was of the “Mary Schapiro go-slow school” of accounting convergence. He was referring to the skepticism expressed by the new SEC chairman about the fast-track convergence roadmap envisioned by her predecessor, Christopher Cox.
Indeed, there may be a considerable downside to a principles-based approach. To some issuers, principles can simply mean “fuzzy rules” that can be evaded if the companies don’t like them, said Hepp. On the other hand, it can mean “a rule with no exceptions” like the standard IASB and FASB are working on that will simply say: “All leases are on the balance sheet.”
“I don’t think a lot of people who are advocating principles-based [standards] are going to be nearly as happy” about that, said Hepp.
Similarly, an audience member told the panel — which was moderated by CFO.com editorial director Tim Reason and included Fred Schea, chairman of the Institute of Management Accountants — that investors haven’t been all that receptive to the judgment that would be the linchpin of a principles-based system.
Citing the current uproar in Congress about fair-value accounting and the recent reactions of equities markets to banks when they mark their assets down in accordance with falling market values, the participant said, “I’m not sure we’re ready to exercise judgment in these areas at all.”
FASB’s controversial standard No. 157, which outlines how companies should measure the fair value of their assets and liabilities, requires considerable judgment on the part of the issuer — and has accordingly drawn considerable heat.
Under the rule, an issuer using fair-value measurements must place its assets or liabilities in one of three levels. In Level 1, the value of an asset or liability stems from a quoted price in an active market; in Level 2, it’s based on “observable market data” other than a quoted market price; and in Level 3, fair value can be determined only through “unobservable inputs” and prices that could be based on internal models or estimates. Level 3, which largely covers assets in illiquid markets, is more commonly dubbed “mark to model.”
Hepp noted that, in fact, there’s a provision in 157 that does let issuers employ judgment. “If you think a price from an illiquid market is not representative, you can go to Level 3, and then you can use mark to model,” he said. “But,” he added, “it’s very difficult, I can tell you, for an auditor to do that. That conflicts with auditing theory, which always tells you that a Level 2 quote is better evidence.”
The guidance issued by FASB and the SEC in October 2008 on how to apply 157 may have further damaged Americans’ ability to rely on judgment in accounting, according to Sherman. Before the guidance, he said, he thought of compliance with the standard as a fairly objective matter. The guidance, however, reminded issuers that if they thought a Level 2 measurement was the product of an invalid, illiquid market or simply was “not a good number,” they could evaluate the asset under Level 3 — and thus make their own estimate, the professor said.
Such an interpretation inevitably leads to a question: How much lower would the value of the assets now measured at Level 3 have been if they were measured at Level 2? “It leads to a kind of cynicism, to ask that kind of question,” Sherman observed.