After Enron: Let’s Not Throw Out the Baby

By Dennis R. Beresford

We have seen and heard a great deal of criticism of accounting and auditing practices in the United States as a result of Enron and other high-profile cases. While it is certainly appropriate to consider whether changes can be made to lower the chance of similar problems occurring in the future, these efforts must keep in mind that our current system of financial reporting produces excellent information in the vast majority of situations. We must keep the criticism on a constructive level and ensure that reform leads to improvements in the current system rather than damages it.

As a former standards setter, I am aware of the dangers of the law of unintended consequences faced by all rule makers. In trying to resolve one issue, a rule often creates other problems that were never intended. The less thorough and considered the process leading to the new rule, the more likely this will occur.

Understanding Financial Reports Requires Education and Diligence

FASB Concepts Statement 1, “Objectives of Financial Reporting by Business Enterprises,” states:

Most businesses are complicated, and any attempt to portray their economic activities in a few financial statements and accompanying footnotes neces-
sarily involves numerous tradeoffs. Consequently, relatively few investors are experts at reading corporate financial reports.

I note this primarily to dispel the notion that financial reports must somehow become fully understandable to any individual who invests in stocks or bonds of public companies. This will never happen. While we should strive to make those reports more accessible to all, a more realistic objective is to work on improving information so financial analysts, lending officers, rating agencies, and other relatively sophisticated intermediaries can use that information to provide better advice to investors.

Congress’s Involvement in Technical Accounting Issues

I was pleased to see one of the comments in former SEC Chairman Arthur Levitt’s New York Times op-ed piece of January 17. In referring to FASB, he said, “This important agency must also be free from Congressional pressure, which is often applied when powerful corporations seek to undermine new accounting rules that might hurt their earnings.”

I strongly agree that Congress must guard against becoming a hindrance to the accounting standards-setting process. A case from my personal experience illustrates how Congress can become too involved in the technicalities of the reporting process: the debate over accounting for employee stock options in the early and mid-1990s. The business community and accounting firms strongly opposed this proposal, and a number of corporations engaged in a lobbying effort to block FASB’s initiative.

The appeals from corporate executives persuaded certain members of Congress to introduce legislation to counter FASB’s proposal by prohibiting public companies from following any final FASB rule on this matter. More importantly, the legislation would have imposed requirements that the SEC repeat FASB’s process on any new accounting proposals, thus effectively eviscerating FASB. Faced with the strong possibility that its purpose would have been eliminated by this legislation, FASB made a strategic decision to require companies to disclose the effect of stock options in a footnote to the financial statements but not record the expense in the income statement.

Unfortunately, this is not the only example of congressional interference in FASB’s technical decision making. In the 1970s, Congress overrode FASB with respect to the accounting for oil and gas exploration costs. More recently, legislation very similar to that proposed concerning stock options was introduced in connection with accounting for derivative financial instruments. For the even more recent project on accounting for business combinations and goodwill, congressional hearings were precipitated by corporate complaints of the alleged unfavorable economic consequences of FASB’s proposals. And legislation was proposed that would have delayed implementation of that new accounting rule.

Congress, of course, has both the right and the responsibility to provide strong oversight in this area. FASB holds a public trust and Congress’s is entitled to examine how it carries out that duty, particularly in trying times like these. However, Congress’s primary role in this area should be to see that FASB is fulfilling its public obligations appropriately. Congress ought not to interfere with individual technical decisions.

The SEC’s Role

In the past several years, working relationships between the SEC and the accounting profession have become increasingly strained, even confrontational. Based on many conversations with auditors and corporate executives, I sensed a much more cynical attitude on the part of many of the SEC’s accounting staff. Too often, an attitude of “you’re obviously guilty of some wrongdoing if you have to come see us” was in evidence when some companies or auditors approached the SEC staff to discuss contentious issues.

Whatever the cause, companies have become more reluctant to seek SEC input on the front end of difficult accounting matters. Recent comments by SEC Chairman Harvey Pitt and Chief Accountant Robert Herdman, encouraging companies and auditors to talk to the SEC on the front end, represent an extremely positive step. While the SEC has enforcement powers to correct reporting that is identified as being inappropriate, it lacks the resources to review all companies’ reports and determine their propriety and must rely on the private sector (corporate executives and independent auditors) to do the right thing. For the reporting system to work best requires a high degree of trust among regulators, reporting companies, and auditors. Therefore, I commend Pitt and Herdman for their efforts to create a more positive environment in which all interested parties can work together to improve each company’s reporting and the overall system. At the same time, I am confident that the SEC will act decisively when individual companies or their auditors have not performed in a professional manner.

The Time Issue in Issuing Accounting Standards

In Chairman Pitt’s public statement announcing his proposal for a new auditing profession oversight board, he admonished, “We need more prompt action by the FASB, the nation’s accounting standard setter”—a comment I agree with 100%.

FASB has explained many times that it deals only with topics for which many solutions are highly controversial. Accordingly, FASB needs a certain amount of time to properly research those matters, debate them, and then seek public comment on the preliminary conclusions. Also, FASB’s open due process (including comment periods for constituents to submit their views on proposals, field-testing of proposals, public hearings, and other procedural steps) necessarily adds time.

This due process allows all interested parties to have the opportunity to inform FASB about pertinent information relating to the matter in question and challenge its preliminary thinking. Such an open process leads to better standards and also contributes to FASB’s credibility in the business community. Efforts to achieve quicker solutions to new accounting challenges should not come at the expense of significantly shortcutting due process.

Rather than reducing its interaction with constituents, I believe that FASB could reach earlier resolution on many projects by streamlining its internal processes. There are at least three ways to do this:

However, the board is able to move only as fast as the staff can prepare matters for its consideration. Increasing the staff by 10 to 15 people would almost certainly allow projects to be considered more rapidly. This would, of course, require additional funding. It would also require finding enough qualified people willing to work for FASB, which has not been easy in recent years.

Accounting Rules Have Become Too Complex

Notwithstanding the complexities of today’s business world, I have a major concern that accounting rules and regulations have become too complicated and that this has added to the burden of those who are reasonably informed and are reasonably diligent about studying corporate reports. Corporate executives and auditors who have direct responsibility for delivering financial reports to the public have a very difficult time keeping up with and understanding all of the accounting rules. For example, FASB’s pronouncement on accounting for derivatives is about 250 pages long, and a Derivatives Implementation Group (DIG) met for over two years to develop a few hundred additional pages of interpretive guidance. I’ve heard senior partners of major accounting firms say that only a handful of specialists within their firms are fully conversant with all of the rules on this important topic.

I certainly don’t mean to pick on FASB—after all, much of the derivatives project was well along before my term ended in 1997. But things have become too complicated, and it is time to step back to see if more general standards can work as well or better.

To a certain extent, FASB took a step toward more generalized standards in its recently completed standards on accounting for business combinations and goodwill. Those standards are still complicated, but they provide for a considerable amount of management judgment in deciding whether and when the value of goodwill has become impaired, for example. Some parties will, no doubt, call for more rules to specify how to make those impairment decisions, and I urge the FASB to continue to resist those requests. The overemphasis on detail will not be reversed overnight. Over time, however, this is something that I believe FASB must strive for.

Accounting standards are necessary in order for reports by various companies to be reasonably comparable. Without some standardized approaches to accounting, sorting out the winners and losers in the business world would be much more difficult. Like the compromise over instant replay in the NFL, however, often the parties involved in the process are willing to accept fewer or less specific rules so that the game flows more smoothly but still within some appropriate boundaries.

In January 2002, FASB announced that it “discussed a number of potential projects to simplify the U.S. accounting literature in order to improve its effectiveness and usability.” Among the actions that FASB decided to take was to “[e]valuate the feasibility of issuing standards that are less detailed and have few, if any, exceptions or alternatives to the underlying concepts.” This is a good first step, and I look forward to FASB reducing complexity of accounting standards over time.

Some will argue that if FASB makes its standards more general and limits the amount of detailed guidance they provide, it may lead to more inconsistencies in financial reporting. However, to the extent that the FASB staff, the SEC, accounting firms, or others identify such inconsistencies, the FASB Emerging Issues Task Force (EITF) can deal with them on a timely basis. The SEC has indicated a desire to work more closely and cooperatively with the EITF in providing guidance on new issues that demand quick attention. FASB should keep this in mind and be willing to limit its standards to more general approaches in the future.

International Accounting

To some extent, the degree of detail in accounting standards has been described as general vs. detailed, or principles vs. rules-based. An article in BusinessWeek suggested that the off–balance sheet financing vehicles used by Enron would never have been allowed in the first place under European accounting. The article noted that the new International Accounting Standards Board (IASB) is using a principles-based approach and avoiding the U.S. tendency toward very detailed rules. Applying principles, auditors in Europe supposedly would have been able to stand up to clients and insist that SPEs be accounted for on the balance sheet. Furthermore, according to the December 13, 2001, issue of the U.K. publication Accountancy Age, “Sir David Tweedie, International Accounting Standards Board chairman, and Allan Cook, UK Accounting Standards Board technical director have indicated Enron’s collapse could not have happened under existing UK or global rules.” The article also quoted Cook as saying, “The IASB would probably have got it on the balance sheet.”

In evaluating such remarks, keep in mind that Enron corrected its financial statements to consolidate the troublesome SPEs in order to comply with existing U.S. GAAP. Furthermore, we should consider any such remarks about other countries’ accounting standards within the context of the rigor of auditing practice and regulatory enforcement, in which U.S. practice is far superior to the rest of the world.

Again, I support less-complicated and less-detailed accounting principles, which is the approach that the IASB is pursuing. That said, on balance, our U.S. financial reporting system remains the best in the world because of the combination of comprehensive accounting principles, required audits by independent accountants, and regulation and enforcement by the SEC. No other country has an overall system of financial reporting that is as reliable and informative as ours.

The IASB’s activity should be commended and supported by U.S. parties, but at the same time I believe it is imperative that neither the SEC nor FASB take action in the near term that would effectively water down U.S. GAAP. Convergence of accounting standards around the world is an admirable long-term goal. But for at least the next five to ten years, we must not dilute U.S. reporting solely for the purpose of harmonization.

Funding FASB

One of Arthur Levitt’s recommendations in his New York Times op-ed piece was to establish alternative funding for FASB in order to improve its independence from the business community and accounting firms. This would allow the organization to cover its operating expenses through a “broad-based user fee,” in Levitt’s words. A number of alternatives for funding FASB have been suggested in the past, and this matter is certainly worth further consideration by the FAF trustees and other interested parties.

At present, approximately two-thirds of the FAF’s annual budget comes from selling publications and similar operating activities. The remaining one-third represents voluntary contributions made by the AICPA, individual accounting firms, and approximately 1,000 corporations. The total contributed by corporations represents about 15% of FASB’s total budget, and individual amounts generally do not exceed $50,000 (the vast majority are much less). Although corporations occasionally threaten to cease contributing if FASB adopts a certain technical position, the actual number of donors who do this is very small.

One possibility is to assess a fee on all public companies and perhaps other parties interested in the financial reporting process, such as accounting firms and investment banks. This is apparently what Levitt has in mind, and if this could be done through the stock exchanges or in some other way that does not involve the government, it may be worth pursuing. However, the SEC or even Congress would probably have to get involved in such an arrangement, and such a relationship would be detrimental to FASB’s independence.

One advantage of the present system is that FASB’s partial dependence on voluntary contributions subjects it to a sort of market test of its effectiveness. FASB’s technical actions are, and should be, independent in nature. However, FASB should not be so distanced from its constituents that too large a number of them become unwilling to continue financial support. Most contributing accounting firms and corporations recognize that they are not going to get their way on technical issues just because they make a contribution. But if FASB were to act in a way that ignores the input of constituents, the contribution mechanism is a way for them to express their dissatisfaction.

Audit Committees

While audit committees play an important role in the reporting system, they do not have primary responsibility for appropriate financial reporting. That duty ultimately rests with corporate financial management, and independent auditors play a critical part as well. But the audit committee can set an important tone at the top. Audit committee members also can ask tough questions of management and outside auditors, and demand answers that they can understand. But even the best audit committee is no guarantee that financial reporting problems will not occur.

There is one area where I think audit committees can be improved: qualifications for membership. While all members are presently required to be “financially literate” and at least one must have “accounting or related financial management expertise,” I believe those requirements can be clarified and strengthened. At least a majority of audit committee members should have significant accounting, auditing, finance, or legal expertise, and general management responsibility without direct involvement in one of those areas should not be sufficient.

Also, the person with “accounting or related financial management expertise” should have strong skills in that area. Since the introduction of the new audit committee membership requirements, there appears to have been only a trickle of new board member appointments with backgrounds as CFOs or controllers or as audit partners from accounting firms. Making these requirements more stringent could encourage companies to invite more individuals with a CFO or audit partner background to join their boards. And adding legal expertise to audit committees could aid committee members in understanding the complex organizational and transaction structures employed by many companies today.

Significant accounting, auditing, finance, and legal expertise are essential prerequisites for members so that they will not be intimidated by the complex issues presented to them. Members with such qualifications are more likely to ask management the probing questions necessary to ensure an understanding of the substance of the issues brought to their attention. In particular, members with audit expertise will be better able to effectively judge the performance of the internal and outside auditors.

Raising the bar for audit committee membership will not by itself protect against future Enrons, but it should certainly help improve the overall quality of financial reporting.

Improve the Current System, Don’t Throw It Out

This is a critical time for financial reporting and the auditing profession. The issues raised by the Enron matter and other recent business/accounting/auditing failures must be studied and used to evaluate changes to the system. It is equally important, however, not to throw out the baby with the bathwater. The current system is not perfect but it works well in the vast majority of cases. Changes to the system should build upon its strengths rather than undermine it.

My principal suggestions for improvement are as follows:

©2002 CPA Journal. Legal Notices