ACCOUNTING STANDARDS

Wisdom from the World of Dogbert

By Dennis R. Beresford

I'm sure all readers have a favorite philosopher. Mine happens to be Scott Adams. If that name doesn't ring a bell, he's the fellow who draws the Dilbert cartoon strip, and he also writes some very good business advice books. If you are a regular reader of Dilbert, you may recall a fairly recent strip where Dogbert, Dilbert's faithful canine companion, was setting up his own mutual fund. Actually, Dogbert was really just stealing investors' money under the guise of an investment vehicle.

Dilbert asked Dogbert whether investors wouldn't become suspicious when Dogbert reported his operating results, which would simply show Dogbert raking off all the cash for his personal benefit. Dogbert replied, "of course not" since he would show that his results were comparable to returns earned by the S&P 500 assuming that an unscrupulous dog managed those companies.

That entertaining example helps explain why our society has developed so many standard measures of performance, whether they are for baseball batting averages, mutual fund returns, or financial reporting. If everyone were allowed to determine his or her own measures like Dogbert, we would have chaos. Of course, some would argue that standards generally are a good idea, but in certain circumstances standards can produce more harm than benefit.

For example, if you had been watching the CNN Moneyline program on October 9, 1997, you would have seen an excerpt from Senator Phil Gramm's (R-TX) hearing on the FASB's derivatives and hedging project. The CEO of Hershey Foods testified that if his company were forced to follow the FASB's accounting proposal on this topic it would
have a devastating
effect on Hershey. Senator Gramm responded, in what may or may not have been a serious comment, that Congress simply couldn't take a chance on a national treasure like the Hershey bar being harmed --the inference being that he might have to take action to stop
the FASB from
causing such asserted carnage.

Many others have weighed in on the FASB's derivatives project. For example, editorial writers in several major publications have expressed various points of view. When I say various, I really mean that, because the views have been from one extreme to the other. Two of them stand out in my mind.

Holman Jenkins, writing in the Wall Street Journal on September 16, 1997, said the following, "Accounting, first of all, is a business tool, allowing companies to get a clearer view of their costs and profits." It's hard to argue with that statement, but Mr. Jenkins went on to say, "The time may be coming when we can thank the profession for its past contributions to the policeman role and allow it to move on." As I read Mr. Jenkins, he basically argues, without any real supporting rationale in my opinion, that accounting standards are no longer needed and certainly the FASB has outlived its usefulness.

Just a few weeks later, on October 12, 1997, Floyd Norris expressed an opposite point of view in the New York Times. He said, "The (FASB) process has produced the best accounting anywhere and has helped to make New York the financial capital of the world." Thus, he links high quality financial reporting with efficient capital markets as many others have done. Mr. Norris concluded his piece by saying, "It is time for businesses, even those that don't like the derivatives proposal, to tell the politicians to leave accounting alone."

These "dueling columnists" present a succinct summary of the battle that has been going on for some time on the derivatives and hedging project. While this one accounting issue is a very important one, the ultimate stakes may be much higher. In addition to whether we end up with more credible financial reporting for derivative financial instruments and hedging activities, I believe the very survival of accounting standard setting in the private sector is at stake if this project becomes overridden by political activity like the stock options project.

In the rest of this article, I will address three questions:

* Why do we need accounting standards in general?

* Why do we need a standard on derivatives and hedging in particular?

* Will the current political activities undermine the FASB?

The Need for Accounting Standards

As to the first point, I hope my Dogbert example may already have made a convincing argument for the need for standards. The Floyd Norris column I mentioned earlier also made a case for accounting standards. He pointed to the situation over 60 years ago when the SEC was brand new and it found that "deplorable accounting was showing up in corporate financial reports." Because full and fair disclosure has always been a hallmark of the SEC, it decided that accounting improvements were needed. It thought about doing the job itself, but by a three-to-two vote the commission decided to place its trust in the private sector to set standards. The rest, as they say, is history and we've had the Committee on Accounting Procedure, the Accounting Principles Board, and now the FASB--each an improvement on its predecessor.

Ed Jenkins, the new chairman of the FASB, and no relation to Holman Jenkins as far as I know, described why accounting standards are needed in his recent testimony to Congress. He said, "Standards are essential to the efficient functioning of the economy because investors and creditors rely heavily on credible, concise, and understandable financial information." Ed went on to say, "The focus of the FASB is on consumers--users of financial information such as investors, creditors, and others. We attempt to ensure that corporate financial reports give consumers an informative picture of an enterprise's financial condition and activities and do not color the image to influence behavior in any particular direction."

Of course, you would expect Ed Jenkins to speak in favor of the need for accounting standards. But let's go back once more to Holman Jenkins. Remember his comment about accounting being a business tool? Well, tools aren't very useful if they come in irregular sizes and don't match up well with the task that needs attention. With reasonable standards, when Company A and Company B each say they have net income of $1 million we have confidence that a relatively meaningful comparison can be made. Without standards, we have no assurance, for example, as to whether Company A is counting future orders as current sales or leaving out many of
its expenses.

The Derivatives and Hedging Project

Why the Project? Having given you at least a few arguments in favor of the general need for accounting standards, let's move to the derivatives and hedging project. Why did the FASB decide to start working on this project several years ago, during my tenure as FASB Chairman? The main reason, which is the case for most FASB projects, is that many constituents asked the board to act. In part, the project was precipitated by large losses suffered by several corporations on derivatives. Regulators, investors, and newspaper reporters asked, "Why weren't these problems identified earlier through better accounting standards?" So accounting firms, the SEC, financial analysts, and many others urged the FASB to improve the accounting in this area.

But it wasn't just a case of a few large losses. As you know, there has been a tremendous explosion in the derivatives market in the past 10 years or so, and the accounting just hasn't kept up. The greater availability and acceptance of options pricing models like the Black Scholes model for which Professors Scholes and Merton recently were awarded the Nobel Prize have fueled this growth.

If you read the FASB's Basis for Conclusions you will find the following reasons for the project listed:

* The existing accounting guidance for derivatives and hedging was incomplete.

* The existing accounting guidance for derivatives and hedging was inconsistent.

* The existing accounting guidance for derivatives and hedging was difficult to apply.

* The effects of derivatives were not transparent in the basic financial statements.

Project Opponents. Of course, many parties reject the FASB's arguments and would prefer the status quo. During the exposure period for the June 1996 FASB proposal, a large number of comment letters asserted that the current rules were working well and resulted in reasonable consistency. Banks, in particular, have led the fight to defeat the FASB's proposal. Their principal hedging tool is the interest rate swap, which is generally accounted for under current practice at zero until cash changes hands. The SEC, which sees how larger banks and all other public companies actually account for and disclose these transactions, strongly disagrees with the bankers and believes the status quo is unacceptable.

I should add that the SEC did not push for any particular solution--it simply believed that improvements are vital and it wanted the board to enact improvements as soon as feasible. This is not a new position for the SEC. Chief Accountant Mike Sutton and Chairman Arthur Levitt have, for some time, been urging the FASB to improve the accounting for derivatives and hedging. When Arthur Levitt became chairman over four years ago, he visited the FASB at my invitation just a couple of weeks after he took office. Even though accounting for stock options was the hot issue at that time, Mr. Levitt told me he considered the FASB's three highest priorities to be derivatives, derivatives, and derivatives. And Mr. Levitt repeated that admonition to me many times over the past four years.

Banks and some other companies continued to argue that the proposal would be "bad accounting" because only certain financial assets and liabilities would be marked to market in the balance sheet. In particular, they observed that stockholders' equity would become more volatile under the FASB's proposal. But their arguments went beyond technical accounting matters.

They expressed specific concerns that adopting the FASB's rule would somehow limit banks' ability to properly manage risk and they also expressed general concerns about possible impacts on capital markets and even on job creation. An article in the October 2, 1997 issue of the Wall Street Journal quoted a few bankers saying things like:

* Following the FASB's accounting may force banks to drop the use of derivatives.

* It could prevent homeowners from buying new cars, taking much-needed vacations, and helping pay for a child's education.

So the FASB stands accused of not only threatening to kill the Hershey bar but also of trying to eliminate all these other important aspects of American life! Of course, most of these kinds of allegations about so-called "economic consequences" are pretty difficult, if not impossible, to prove and even members of Congress usually are not persuaded by them in the final analysis.

Due Process. So the banks and other opponents revised their strategy somewhat and began attacking the board's due process procedures, saying that the FASB hadn't thought enough about this topic and should do more work before reaching a final answer. In fact, the requests by several industry groups and individual companies to involve Congress in this exercise largely were based
on those claims about procedural
deficiencies.

In response, the FASB patiently explained it had been working on this project for at least six years and its procedures included exhaustive research and deliberations. For example, the FASB cited the following:

* A research report and discussion memorandum were prepared early on and both invited preliminary comments

* Over 100 public meetings were held for the board to deliberate the issues--I can vouch for that as I was in charge of about 95 of those meetings.

* An exposure draft was issued, over 300 letters were received and considered, a field test was performed based on the ED, and public hearings also were held.

* The FASB subsequently redeliberated all of the issues and made a number of important changes to the earlier proposal to address many of the concerns expressed in comment letters and otherwise.

* The final statement was released in draft form to interested parties for an additional 45 days of comment--further changes were made as a result of those comments.

It is hard to think of any other activity that has been as thorough, as open, and as willing to listen to constructive suggestions. Nevertheless, at least some parties will continue to argue for "more process" unless the board finally gives in to their point of view on the issues.

The FASB's Conclusions. What about the specifics of the FASB's rule? A complete analysis of the document is beyond the scope of this article. But suffice it to say that the board made numerous, substantive changes to respond to many of the arguments put forth in comment letters and other requests for change.

The key elements of the exposure draft remain--to require all derivative financial instruments to be recognized at fair value in the balance sheet and to provide reasonable discipline on what will qualify for hedge accounting treatment. But the board made changes that, in the vast majority of situations, will allow matching in the income statement of market value gains and losses on derivatives and offsetting losses and gains on hedged positions. The board also agreed to extend the effective date so that companies should have at least a year to apply the final statement for the first time. And the board made many other important changes to the earlier draft to accommodate more specific concerns expressed by various parties.

A large number of constituents have welcomed these changes and now support the final document. For example, after reviewing the changes at a July 1997 meeting, members of the Financial Accounting Standards Advisory Council were generally supportive--one member was quoted to say that the changes made by the board to the exposure draft "are responsive to comments received." A representative of General Motors was quoted in the Wall Street Journal as having said, "We believe the proposed standard, in its current state, represents a significant improvement to the accounting model for derivatives and hedging activities, and we support its issuance without re-exposure."

Not all parties agree, of course. If they did there would hardly be a need for anyone to set standards. And those that haven't been satisfied by the FASB's changes to date are the ones that have appealed their case to Congress.

Congressional Interest

Congressional interest in accounting matters or even hearings are not new phenomena by the way. During my time at the board almost every major project attracted at least some attention from Washington, D.C. including the accounting dealing with:

* Income taxes

* Post-retirement benefits

* Marketable securities

* Loan impairment

* Mutual life insurance

* International accounting

* Fair value for financial instruments

* And, of course, stock options.

The level of interest from Washington varied quite a bit and ranged from mild letters from Representatives or Senators on behalf of a constituent to proposed legislation. The level of activity on the derivatives project is much less than on stock options so far but also somewhat more than on most of the other topics I just mentioned.

If Congress would take some sort of action, the real question is whether it would take standard setting away from the FASB or "only" modify the outcome of the derivatives and hedging project. You may have read that John Reed, the CEO of Citicorp, has urged Congress to close down the board and have the accounting standard setting revert to the SEC. Mr. Reed dislikes the idea of a body whose sole responsibility is to set accounting rules--he feels that objective motivates the FASB to do too much. Mr. Reed also notes that the SEC has plenty of other matters on its plate and might not give such a high priority to accounting. I think he also believes it would be easier to influence the SEC through
political lobbying-type approaches as compared to how he can interact
with the FASB.

But Mr. Reed may be overlooking the fact that much of the authority over accounting matters is vested in a single individual at the SEC versus the great difficulty the FASB has in getting at least five of seven board members to agree. I really question whether he would support an activist chief accountant making unilateral decisions on important accounting issues versus the "safety in numbers" approach we now have at the FASB.

In any event, the SEC itself has strongly resisted Mr. Reed's suggestion--Arthur Levitt opposes it as did his predecessors David Ruder and Richard Breeden when Mr. Reed raised the idea on earlier occasions. The SEC continues to believe it can best leverage its own resources by leaving accounting standard setting with
the FASB and maintaining its oversight of the board.

At this point congressional pressure on the FASB has been limited mainly to some intense jawboning. A number of members of a House of Representatives committee signed a letter to the FASB dated October 7, 1997 that urged the board to do the following:

* Allow more time for comment on the draft of the final statement.

* Give further consideration to alternatives, specifically one suggested by Federal Reserve Chairman Greenspan that would require more footnote disclosure about derivatives but would not change the basic accounting.

* Defer the implementation date of a final statement still another year.

* Provide more guidance on how to determine the fair value of financial instruments.

In addition, just a couple of days before Congress finished its 1997 work, Senator Lauch Faircloth (R-NC) introduced a bill that, in his words, would "put a check on new FASB rules" on derivatives. Senator Faircloth's bill would apply only to depository institutions and would require Federal banking regulators to certify that a new FASB standard would accurately reflect earnings and not diminish risk management practices that would inhibit safe and sound operations.

This bill, of course, would have to be introduced again in the 1998 congressional year, and there is no indication that it has general support.

Will Congress do anything more? I have no doubt that at least some aggrieved companies will continue to seek relief through their friends in Washington. Thus, it ain't over 'til it's over--and in this case it's not over even then as efforts are likely to continue past the issuance of a final FASB statement and up to at least the statement's required application date.

My Views

Roger Lowenstein, another Wall Street Journal columnist, referred to the earlier accounting war over stock options when he said the following on September 11, 1997, "If the losers get redress in Washington for every rule they deem imperfect (and believe me, without imperfect accounting rules there wouldn't be any at all) the FASB may as well call it quits."

I have to confess to being an eternal optimist, but I really believe that the derivatives situation is not the same as for stock options and further government interference is not highly likely. I think that, on balance, this is more like the normal amount of controversy that is a regular part of the FASB's activities, similar to some of the other technical topics I mentioned earlier that also attracted attention from Washington.

Unlike the stock options issue, for derivatives there are strongly held views on both sides of the question. For stock options, nearly every interested party opposed the FASB's exposure draft. For derivatives there are strong supporters as well as strong opponents--that's the normal state of affairs in standard setting. And the SEC supports the FASB on the derivatives project--for stock options, the SEC did not stand behind the board in the final analysis.

The many changes made by the FASB to the derivatives exposure draft have addressed the problems brought up by a high percentage of those who complained earlier so that remaining opposition is much more concentrated--again, unlike the stock options project. And, perhaps most importantly, in the case of stock options, there was legislation pending in Congress for which there was a very strong indication of likely success--the derivatives activity hasn't come close to that stage yet.

If I were still at the FASB, I would continue to work with companies and others to provide as much implementation assistance as possible. And I would closely monitor the progress that companies are making in their implementation efforts. If it appears necessary to give them another six months or year to implement the statement on a cost-effective basis, I would extend the effective date
accordingly.

Obviously, I believe in the need for accounting standards and in the FASB. Otherwise I wouldn't have spent the last 10 years becoming a CPA--that's a Criticized but Persevering Accountant. And having led the drafting of the FASB's proposal and much of the redeliberations, I strongly support the final statement. It has been improved significantly by adopting many of the constructive suggestions made by constituents.

But I also share the concerns of Arthur Levitt, Roger Lowenstein, Floyd Norris, and others who believe the fragile foundation underlying the FASB could be fatally damaged if we are not vigilant in supporting the board. As Mr. Levitt said in a recent speech, "The true test of a democratic institution is whether it is respected even by those who disagree with its decisions. If we don't abide by FASB's decisions when they go against our interests, then we will seriously undermine, and ultimately destroy, the institution."

I think all of us in the accounting profession should be proud we are allowed to control this important part of our destiny. But it is something we must fight to support or others will take it away. Some people in Washington, D.C. and elsewhere have said that accounting may be too important to be left to the accountants. If you disagree with that statement, as I do, I hope you will stand up and be counted when needed. *

Dennis R. Beresford, CPA, is Executive Professor of Accounting at the J.M. Tull School of Accounting, University of
Georgia. From 1987­1997 he was
chairman of the FASB.

In Brief

Will the derivatives project go the way of stock options?

The very survival of accounting standard setting in the private sector is at stake if the project on derivative financial instruments and hedging activities becomes overridden by political activities like the stock option project.

The derivatives and hedging project was started at the request of many constituents. Existing accounting guidance was considered incomplete, inconsistent, difficult to apply, and the effects of derivatives were not transparent in the basic financial statements. Banks, in particular, have led the fight to defeat the FASB's proposed accounting. Opponents eventually revised their strategy to attack the board's due process procedures, despite the fact the board has worked on the project for six




years and included exhaustive research and deliberations.

Almost every major project of the FASB has attracted at least some attention from Washington. The level of activities on this project is much less than on stock options but somewhat more than on most other topics. If Congress would take some sort of action, the real question is whether it would take standard setting away from the FASB or only modify the outcome of the devivatives and hedging project.