Complexity in accounting is sometimes necessary when the transaction or economic event is complex. Some measurements will always be complex when there is the lack of significant observable data with which to make an estimate.
But much of the current complexity in accounting standards is unnecessary. This excess complexity is usually supported by CFOs and other corporate preparers of financial statements (who would most benefit from simplification of the standards) because of a desire to avoid the effort to undergo major changes in accounting standards.
Further, corporate preparers don’t want to give up the flexibility to manage financial reporting that is provided by many current complex standards. They cause excess complexity by pushing for provisions aimed at smoothing the impact of economic changes over time, rather than recognizing them when they occur. They also want to incorporate the preparer’s intent – which, of course, is subject to change as circumstances change – in recognition and measurement standards.
Complexity is also caused by the Financial Accounting Standards Board. The board creates complexity by trying to limit the amount of major change in standards. It has a hard time identifying a basis for a standard and sticking with that basis. Many times a second approach is developed in a standard to limit the amount of change. Additionally, the current set of accounting concepts that should guide the FASB in developing standards is incomplete and in need of improvement.
In 2014 the FASB started devoting significant resources to eliminating complexity in a number of narrow-scoped projects. Those projects are addressing the complexity of accounting standards on the fringe.
Offsetting even those narrow efforts is the creation and retention of unnecessary complexity in two major projects: leasing, from the standpoint of the lessee, and accounting for debt instruments (more on these below).
Preparers of financial statements support simplification of accounting standards as a general idea. But when they provide input to the FASB on projects that propose significant change to current standards, they usually fight to retain the current standard. Often, preparers agree that there is a significant problem that needs to be corrected at the start of an FASB project. But by the time a solution is proposed, the problem seems to have disappeared – and the status quo is fine.
Accounting standard-setters are human. They don’t want to ignore the input from preparers to limit the amount of change in standards. Sometimes it is hard not to feel like the Grinch who stole Christmas in the face of calls not to change too much.
Also, the professional experience of many FASB members is similar to that of preparers. It’s hard for some board members to recognize that their role as a standard-setter requires a different balancing of their past experience with their new duties. Such a balanced perspective would likely move standard-setters to inject simplification into their major projects even if it creates major change. The cost of this effort to the standard-setter is that they would be even more unpopular.
The long-term benefits of simplified standards are many. They make it easier for preparers to know what to do in accounting for transactions or economic events. In most cases, fewer systems and data distinctions are needed. Mistakes, second-guessing and restatements are less likely to occur. Fewer and more effective internal controls can be developed. All those factors lead to less costly accounting and, in many cases, more explainable and understandable financial reporting.
Erasing Complexity in Lessee Accounting
FASB’s new approach to lessee accounting appears likely to require a major change from today’s accounting. All leases would be reported on the balance sheet in terms of a right-of-use asset and the financing liability inherent in a lease. But the approach includes unnecessary complexity to retain part of current accounting. Some preparers and the leasing industry lobbied to retain the level expense-recognition pattern that exists for today’s operating leases.
The FASB has tentatively decided to accommodate this desire by requiring preparers to make a sure-to-be-second-guessed subjective judgment as to whether a lease provides the lessee an “insignificant” portion of the value of the leased item or more than an “insignificant” portion. (Although the specific wording for the split may change, the problem is that the FASB has created the need to make a split.)
For leases that provide an “insignificant” portion (known as a Type B lease), the level expense recognition pattern of today’s operating leases would be required. Type B leases would also require a unique amortization method for the right-of-use asset to achieve the level expense pattern. And both the lease’s interest expense and the unique amortization would be combined and reported as one item.
For leases that provide more than an “insignificant” portion of the value (Type A leases), the expense-recognition pattern would be like the one used in acquiring an asset with debt financing (with a higher expense recognized in the early part of the lease term because the larger borrowing amount is outstanding). Type A leases do not require a unique amortization method and interest expense and amortization expense are reported separately. The accounting would be consistent with how the lease is reported on the balance sheet.
What is “insignificant” and what is more than “insignificant”? Why require two accounting systems for recording the cost of a lease in the income statement when one system is required for the initial accounting for all leases on the balance sheet?
If a financing liability is reported on the balance sheet, isn’t it more understandable and informative to have interest expense reported in the income statement? Why provide the leasing industry with an accounting subsidy they can provide to their customers (the level expense recognition pattern) and the opportunity to structure leases to obtain this subsidy when other lenders don’t have this opportunity?
All those issues can be avoided by having only one type of lease and one way to report the cost of a lease in the income statement. The unnecessary complexity proposed for lessee accounting is an example of preparers supporting complexity to avoid a change and of the FASB not sticking with one basis for an accounting standard (the balance sheet approach). Instead the board intends to create a second approach (separating leases based on the degree of the leased asset’s value provided to the lessee) to avoid more change to current accounting.
Erasing Complexity In Accounting for Debt Instruments
To limit change in the accounting for holding debt instruments, such as trade receivables, loans and debt securities, the FASB has tentatively decided to retain all of the complexity in today’s accounting standards.
That complexity includes having different requirements based on whether the debt instrument is in the form of a security or not (securitized loans and trade receivables are accounted for differently than non-securitized instruments) and a classification scheme for debt securities.
Thus the classification scheme would require held-to-maturity securities to be reported at amortized cost. It would require available-for-sale securities to be reported at fair value with the adjustment from amortized cost reported in other comprehensive income, not net income. Trading securities would have to be reported at fair value, with the adjustment reported in net income (trading securities).
The classifications are based on the preparer’s intent of how to realize the value of the debt security. That intent is subject to change as conditions change, tainting (when a security that is classified as held-to- maturity is sold) and second-guessing.
All of this complexity can be eliminated and more information provided in financial statements by reporting all debt instruments (regardless of the instrument’s form) in the financial statement using both amortized cost and fair value.
Using additions and deductions and totals and subtotals, data regarding total assets, equity, net income, and comprehensive income can be displayed using both measurements. Investors would have more information. Preparers would benefit by having fewer accounting systems, internal controls, and judgments subject to second-guessing to maintain and make.
The accounting would be less costly and less subject to being restated if an auditor, the Securities and Exchange Commission or, indirectly, the Public Company Accounting Oversight Board decide that debt instruments are not classified correctly.
Finally the objection to reporting all instruments at fair value is a red herring. Most preparers (especially for public companies) already are required to make fair-value measurements for the debt instruments they hold — the difference is that those measurements are for additional disclosures rather than included in the statements themselves.
A very major change to current accounting for holding debt instruments (including trade receivables) being proposed by the FASB is in the way impairments of most debt instruments are to be measured and recognized. The new method, called the Current Expected Credit Loss (CECL), requires the preparer to consider its own past credit loss experience, current economic condition and their own supportable forecasts of future economic conditions to determine what credit losses will occur over the life of the debt instruments (even if the probability of a credit loss is remote). The estimated credit loss is then recognized at the time the debt instrument is initially reported. Technically speaking, a credit loss is reported when a debt instrument is initially recorded.
CECL results from calls by investors to incorporate forward-looking information into impairment measurement and recognition who thought impairments were reported too late during the last financial crisis. The CECL manner of incorporating forward-looking information is revolutionary. It anticipates and records a loss before it occurs. Because it uses the preparer’s own forecast of the future and its own bias in making that forecast, it creates a new earnings management tool.
The CECL approach is unnecessary. A fair-value measurement already includes forward-looking information about the cash flows expected to be collected. That is unbiased market-place information and is based to the extent possible on observable data. As I’ve mentioned, most preparers are already making fair-value measurements of debt instruments, and internal controls for this system already exist.
The FASB should drop its proposed CECL approach and rely on fair- value measurements to incorporate forward-looking information in reporting debt instruments. That action would result in preparers not having to create a new impairment accounting system and set of internal controls. Further, it would not require a credit loss to be reported when a debt instrument is recorded initially.
The benefits of less complex accounting standards are many, and the biggest beneficiary of simplicity is the preparer of financial statements. Preparers should look to the long-term benefits they will receive and not focus on the short-term cost. Giving up some of the flexibility to manage financial reporting that current complexity provides will improve financial reporting and benefit the capital markets.
The FASB should be providing the adult supervision needed in standard setting. Being unpopular is part of the cost of being a standard setter. Eliminating unnecessary complexity will improve financial reporting and would be a lasting mark of good standard-setting.
Edward W. Trott was a member of the Financial Accounting Standards Board from October 1999 to June 2007.