FASB Charts a New Course

FASB Charts a New Course
An Interview with Robert H. Herz

By Robert H. Colson

In Brief

Principles, Convergence, Reorganization, and Integrity

The CPA Journal’s Editor-in-Chief discussed a wide range of issues affecting the accounting profession with new FASB Chairman Robert H. Herz late last year. Herz explains his views on principle-based accounting, the global convergence of accounting principles, the changing role of accounting standards setters, the quest for more substantial input from users and small preparers and their auditors, and the role of professional societies and accounting trade associations. Herz promises a faster and more independent process for accounting standards setting.

Robert H. Herz became the chair of the FASB on July 1, 2002. Before accepting this appointment, Herz was a senior partner with PricewaterhouseCoopers and a member of its global and U.S. boards. He was also a part-time member of the International Accounting Standards Board (IASB) and is both a CPA and a chartered accountant.

Herz began his public accounting career at Price Waterhouse after graduating from the University of Manchester, England, with a degree in economics. He subsequently joined Coopers & Lybrand, rising to senior technical partner in 1996, a position he continued to hold at Price-waterhouseCoopers after the 1998 merger. Herz has also contributed generously of his time and effort to various committees of the American Accounting Association (AAA), the AICPA, and the International Federation of Accountants (IFAC).

CPAJ: What do you anticipate will be the most significant challenges in the early months of your leadership at FASB?
Herz: I think everyone would probably expect me to pick the hot-topic accounting issues, such as accounting for special purposes entities or stock option accounting. Dealing with such accounting standards issues is on the board’s priority list, but the big challenge for me lies more in forging an agreement between the members of the board and our many constituencies about a new direction for accounting standards in this country. General agreement about a new course at FASB, pointed at the right destination or outcome, will be the largest early challenge that I face.

CPAJ: What course or destination do you have in mind?
Herz: Implicit in my comment is a belief that all is not “hunky-dory” in the financial reporting world, a world where FASB’s standards have a large impact. Our experiences with some of the accounting and financial failures of the past year have reinforced the fundamental principle that the investing public has a right to a good, honest, and meaningful system of financial reporting. While it is clear that most of the bad things that have occurred should not be laid at the door of accounting standards, there is no doubt in my mind that there is room for improvement in the standards and standards-setting process, and that the board can and should play a role in making certain that our financial accounting standards support the best, most transparent, and most meaningful public reporting. So, certainly we have to keep our eyes on the ultimate goal of what we’re trying to achieve.

Between the middle of April, when I was selected to become FASB chair, and July 1, when I began my duties, I conferred extensively with a number of FASB constituencies, including members of congressional oversight committees, the SEC, the Federal Reserve, the Treasury Department, the GAO, corporate executives, accountants, users, FASB board members and staff, the IASB, and the trustees of the Financial Accounting Foundation that appointed me. Although there were many viewpoints expressed, some fundamentally contradictory, several general themes gelled in my mind from those conferences as I came into the chairmanship. These themes are the specific goals I have in mind in response to your question. Let me try to characterize them for you.

The first revolves around the question of principle-based standards. Just about everyone seems to agree that current U.S. standards are overly “rule-based.” They point to the principle-based approach in the United Kingdom and to international accounting standards as qualitatively different from the detailed standards we have seen recently in the United States.

The second theme has to do with the amount of time seemingly necessary to draft, expose, deliberate, and adopt new standards. The timeliness issue appears to be on everyone’s mind, as it is on mine, and we have already begun a study of our internal processes to streamline the board’s own deliberations. FASB remains committed to full and open due process, meaning that timeliness issues will be resolved within those constraints.

The third theme centers on the high expectations for global convergence of accounting standards in the near future, even though there are some significant differences in beliefs about the quality differential between U.S. GAAP and international standards. We plan to work closely with the IASB on reducing the differences, at least on the level of principles, and have already scheduled joint meetings and agreed to joint projects.

The fourth theme deals with what some refer to as the “alphabet soup” of accounting standards setting. This theme also arises in the context of the influence that various constituencies have on accounting standards setting and whether a reduction in the number of standards-setting groups and in the types of pronouncements would lead to more public accountability and, thereby, greater public confidence in the standards-setting process. In order for the board to make headway on the first three themes, we will first have to reorganize how standards are set and agree to changes in the roles of FASB, the EITF, the SEC, and the AICPA.

New Approaches to Standards Setting

CPAJ: You have laid out an extensive and ambitious agenda for FASB, but let’s home in on the issue of principle-based accounting. Can you elaborate on your view of the essence of the difference between principle-based and rule-based standards?
Herz: Everyone seems to think that many of the recent standards are overly specific in prescribing the details of how to account for certain transactions, implying that a principle-based approach would be more conceptual or more comprehensive. Right now, there are two somewhat different views held by constituents about what should be the appropriate level of abstraction for accounting standards. One view holds that the board should promulgate only principles with little specific guidance or rules. In this view, preparers and auditors would have to agree on the appropriateness of the specific application as it embodies the principle. Proponents of this view believe that such an approach would reduce the temptation to structure transactions to comply with or possibly circumvent more specifically crafted rules because the rules’ blueprint for the financial engineers would not be there.

Another view, one which accords more with my ideas, maintains that some specific rules would always be necessary but they should at least be consistent with the underlying principles. Right now, one problem is that some standards are inconsistent with the concept statements as well as with each other. The biggest source of inconsistency of the rules with principles comes, however, from all of the exceptions that are made to satisfy certain constituencies. The best example of this problem has to be SFAS 133. The principle is pretty straightforward, but we have lots of exceptions, the Derivatives Implementation Group’s issues and guidance, and petitions to make additional rules to exempt specific transactions from the principles of fair value or hedge accounting. I would like to do something about making the concept statements and existing standards consistent with one another and dramatically reduce the number of exceptions to principles that we permit.

There is a related issue that comes up in our discussion about principle-based accounting standards that raises questions about the appropriate extent of authoritative guidance and the institutions and processes supporting it. Many believe that one of the causes of the rule-based “syndrome” I talked about earlier is the relatively large amount and multiple sources of authoritative guidance. There is a very real question as to whether detailed, authoritative guidance that answers every question a preparer or auditor could have is possible or even desirable.

Finally, there are some important systemic issues to address in order to achieve effective principle-based standards. We have tried to address many of these in a recent proposal, and we are also working with with the SEC in studying the feasibility of implementing a principle-based approach in the U.S. as part of the implementation of the Sarbanes-Oxley Act.

Many also believe that the one principle that all accountants should adhere to, and one that the board should consider making part of GAAP, is the requirement to place economic substance over form.

CPAJ: You mentioned your concern about the timeliness of FASB actions. What changes do you have in mind?
Herz: Several things have already occurred that should speed our process. The FAF trustees really helped us on timeliness last spring when they approved a change in our voting requirements. Now only four votes rather than five are necessary to issue exposure drafts and final statements. Ironically, simple majority votes were used at the FASB once before, but the process was changed in the early 1990s to require a supermajority in order to slow down the process in response to the complaints from preparers and auditors about standards overload. Now we have changed back to a simple majority in order to speed things up again.

We have also reorganized the senior staff at the board to enhance focus and accountability. Most notably, we have split the responsibilities of the director of research and technical activities into three roles performed by three different individuals. One director focuses on major board projects, another works with the EITF and other implementation activities, and the third deals with internal processes, HR, and special projects. The board meetings are now longer than they used to be, and we address more topics in greater depth than we once did. By spending more time together as a board, we hope to increase our effectiveness and efficiency. The focal point of our meetings with constituent groups reflects our desire for timeliness. Greater time is spent on identifying emerging problems and trends that could affect accounting. We are working with a process-engineering consultant, who is working with board member John Wulff, to identify and hopefully eliminate internal processes that do not add value without compromising our open due process.

Convergence

CPAJ: What will happen with regard to the global convergence of accounting standards?
Herz: There’s a lot to say about global convergence, probably more than your readers would like all at once! Some believe that convergence of U.S. GAAP with international standards is not possible because U.S. GAAP is complex and rule-oriented, while international standards tend to be principle-based. On the other hand, our effort to expose for comment a proposal for principle-based standards in the U.S. indicates the board’s belief that we can come together. Whether there will ever be a single worldwide GAAP can be questioned, but I believe it would be possible to create a set of common principles that each national standards-setter could agree to and then interpret or clarify for the issues in its own country.

There are other cultural, legislative, and regulatory hurdles, too. For example, accountants in few countries face the same litigation risks as accountants in the U.S. Nor do all countries have regulators as powerful as the SEC or legal remedies for perceived accounting principles missteps as here in the U.S. Our standards have become complex rules in response to domestic demands for bright-lines for preparers and auditors to follow in order to avoid enforcement and lawsuits, and in response to perceptions by regulators and others that corporations have too much discretion in their accounting. To say that we desire global convergence is one thing, but achieving it will be much harder and will require compromises by all concerned. If it is critical for the expansion of the capital markets, I would expect to see some infrastructure changes that would make a principle-based approach feasible in the U.S., including a reconsideration of the legal framework surrounding financial reporting.

FASB and the IASB share many core values. We will also be working on a number of projects together and, in some cases, issuing joint exposure drafts. In many areas, there is already agreement in principle. And we have targeted a number of existing differences between our standards to see if we can agree on a common answer. I believe we’ll make significant progress toward this goal during the next few years.

CPAJ: Is there any possibility that we could see GAAP differentiated by company size, as is now done in the U.K.?
Herz: That question arises almost inevitably when you begin talking about global GAAP. In my view, it’s the economics of the transaction that should drive the accounting rather than the size of the company. A small company could have transactions that are just as complex as a large one. There is also a strong culture in the United States that favors a single set of accounting standards that applies to all. Sometimes, however, the cost– benefit equation may be different for smaller businesses as opposed to large companies. Hopefully, as we discuss and study how a principle-based approach could work in this country we will see ways of maintaining a single GAAP that can be meaningfully applied to all entities.

FASB’s Changing Role

CPAJ: Could you elaborate a bit more on the differences in viewpoints between different constituencies?
Herz: One of the things that came through loud and clear when I was making the rounds of all the different constituencies last April and May was the striking differences in viewpoints about the independence of FASB. Just about every constituency thought we were too controlled by some other constituency. For example, many financial statement users and members of Congress felt that both FASB and the SEC had been overly accommodative to the corporate community, allowing too many exceptions in standards and too much flexibility, leading to inadequate disclosure, off–balance sheet financing, and form-over-substance accounting. Corporate executives, on the other hand, felt that FASB had not responded sufficiently to their concerns about disclosure and standards overload, the trade-off between practicality, cost, and benefit, and the adoption of accounting approaches that they believe do not reflect business reality.

The thread that held all these criticisms together in my mind was that standards setters and regulators may have attended too much to the views and needs of preparers and auditors, especially large preparers and their auditors, to the unintended detriment of investors and other users of financial statements. I am committed to expanding the role of investors and users of financial statements in the standards-setting process.

CPAJ: Does this mean a more independent FASB?
Herz: Certainly, everyone I spoke to wants an independent FASB. That’s good news! But it will be up to the board itself to deliver an independent FASB. Everyone seems to be concerned that if the board becomes more independent of them, then it will become captive of some other group. The private sector expressed concerns to me that FASB would become simply an arm of the SEC or the federal government. Some speculated about that possibility during the debate over the Sarbanes-Oxley Act, but the act addresses only the funding of the private sector accounting standards setter.

In fact, receiving funding through a mandated fee on public companies will probably provide the board with a degree of financial independence that it simply has not had in the past. We received funding from the AICPA, the large accounting firms, the large corporations, and the sale of publications. Now, we will be funded largely through a mandatory fee on all public companies. The Sarbanes-Oxley Act provides mandatory funding for FASB, but emphasizes that there is no intent to federalize it or subject it to political pressures. Time and experience will tell us if this arrangement works.

CPAJ: How will these changes affect the work of the AICPA’s Accounting Standards Executive Committee (AcSEC) and the Emerging Issues Task Force (EITF)?
Herz: Our intent is to have the FASB take more responsibility for all aspects of accounting standards-setting in the U.S. I anticipate that AcSEC would not continue to act as an accounting standards setter. The need for the accounting standards setter to be clearly independent has never been clearer. The arrangement that FASB and AcSEC have worked under for many years has been important and valuable but it is now time for a different arrangement. Consistent with the direction of the AICPA in recent years, I would expect that one of its senior technical committees would become involved in developing nonauthoritative industry guidelines. But the standards-setting work that once would have been done by AcSEC will now be done by FASB.

The EITF poses a slightly different set of issues. There clearly remains a need for a group under the auspices of FASB, but still somewhat distinct from it, to deal with issues pertaining to accounting principles implementation. I would expect that the EITF will begin functioning less as an auxiliary standards setter and more as an implementation group for FASB principles. You could look to the relationship between the IASB and its International Financial Reporting Implementation Committee (IFRIC) as a model of how FASB and the EITF could implement a principle-based approach. Finally, I would like to see users of financial statements on the EITF.

CPAJ: You have alluded several times to the desire to have more financial statement user input into the standards-setting process. What steps have you put into place to accomplish this goal?
Herz: Over the years the board has always received valuable input from preparers, auditors, and regulators, and frequently in great quantity. On the other hand, financial statement users have generally communicated with the board much less frequently and effectively. To a certain extent, such an outcome is understandable, because preparers and auditors have the interest and resources to participate effectively in the exposure draft comment process that the board has developed over the years. Evidently, engaging users of financial statements as effectively will require a different approach. We are in the process of establishing a new approach to obtaining the input of users. We have gone to mutual funds, investment and commercial banks, rating agencies, and groups that represent users to gather nominations for a user advisory council. We expect this group to be up and running early in 2003.

We are also sensitive to the difficulties that other groups face in trying to have an impact on the board’s standards-setting process. The large public company preparers and their auditors have the time and resources, as well as the interest, to participate as fully as they can. The board has other equally important constituencies that often do not believe they receive the attention they should. Private companies, not-for-profit organizations, and small accounting firms frequently do not have the same time or resources to expend on keeping abreast of and responding to FASB exposure drafts. In an effort to become more attuned to their needs and concerns, the board has dedicated staff and resources to focus on the issues, needs, and concerns of private companies and not-for-profits.

CPAJ: You have discussed numerous issues facing the board and the responses you either have initiated or plan to initiate. How do you rate the prospects of achieving the goals you outlined earlier?
Herz: I am very optimistic. The environment is primed for us to make significant changes and achieve significant progress on all the goals. One of the positive outcomes of the tragic accounting and financial events of the past year is a willingness to embrace reform and to pay real attention to fundamental professional responsibilities. I am confident that we will see progress on principle-based accounting standards and on international convergence in the near future. It will be up to the board to provide the necessary changes and improvements in the concept statements and the standards-setting process to achieve consistency and to gain the confidence of the investing public.

Accounting standards are, however, only one part of gaining the confidence of the investing public with regard to the integrity of financial reporting. Everyone else, from preparers to auditors to regulators to users, will have to shoulder their part of the responsibi-lity. In a very real way, the past year should remind all of us that accounting and accountability are fundamental, truly fundamental, to capital markets. Our profession functions at the core of accountability, and we will have to do our best to fulfill our responsibilities with utmost objectivity and integrity and a renewed dedication to the proposition that sound, honest, and reliable reporting really matters.