Herz assumed his responsibilities as FASB chair in July 2002 and began his second five-year term on July 1, 2007. Prior to accepting his appointment to FASB, 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). He is both a CPA and a chartered accountant (CA).

Principles-Based Accounting

The CPA Journal: Principles-based accounting has been touted as the way to go for accounting standards. Yet some believe that we will always revert to rules-based standards. Can you explain your understanding of principles-based accounting and how FASB plans to achieve that goal?

Robert H. Herz: To understand my perspective, I should explain my background. I went to college in England and started working as a chartered accountant there. The accounting system there is more principles-based and the corporate governance system is different. Its legal system is also different from the U.S.’s. The capital markets are smaller, and in some ways more transparent. Overall, the U.K. accounting system probably works better there than it might work here.

I believe that the U.S. system has too many rules and bright lines, too much detail, and too much attention paid to providing specific answers to detailed fact patterns. That has come not only from us and the Emerging Issues Task Force (EITF), but also from the SEC and its staff and from the AICPA in various forms. I think that can, and does, undermine professionalism, both in the preparation of financial statements and in auditing. I also think it can make it harder for readers of a company’s financial statements to figure out what was actually done, and it leads to inconsistencies. So I am in favor of what the SEC outlined in its July 2003 report to Congress on a principles-based system, what they termed “objectives-oriented” standards.

I think the SEC also made the point, as FASB has, that you can’t achieve that kind of system just by writing accounting standards. The fact is that accounting standards are part of a larger financial reporting system; therefore, a financial reporting system that works properly involves many elements working together. I think we are trying to articulate broader principles or objectives, explain them, and then, where possible, relate them to real-world examples. We don’t want to get into every possible fact pattern or create unnecessary exceptions. We’re also trying to stay away from bright lines. However, over the past 15 or 20 years, counter to that, many companies and auditors have said, “Just tell me what to do.”

CPAJ: Is that a consequence of the basic nature of our society?
Herz: For good or for bad, a significant degree of second-guessing goes on in financial reporting. Many preparers and auditors therefore say, “Rather than having to think about it, to use my professional judgment, I just want to go home at night and be able to sleep without worrying about everything I did that day.” I think FASB’s effort to move financial reporting toward a more principles-based system is important because many of us believe it will achieve better financial reporting, but it will also take changes by others in the system to make it a reality.

Principles-based reporting is also important from a convergence perspective because many parts of the world don’t use a rules-based approach. Over the last two years I’ve pushed for a national effort to look at the complexity of our financial reporting system. It is not clear from a cost–benefit perspective that we couldn’t have a better system that actually provides more useful and transparent reporting without killing the crew in the process, so to speak. I believe we can do that, but as I said, getting there would involve more than FASB just saying that we’re going to write more principles-based standards. FASB receives many inquiries on specific fact patterns for the principles-based standards we’ve written. So it may take institutional, behavioral, and cultural changes by other parties to make it work.

[In June 2007, the SEC announced the establishment of an advisory committee to explore ways to improve financial reporting by reducing the complexity and increasing the usefulness of reported financial information. In addition to its 17 appointed members, five others, including Herz, will serve as official observers of the advisory committee.]

CPAJ: Perhaps that’s because principles-based accounting requires auditors to exercise their professional judgment, which exposes them to greater risks?
Herz: Yes, auditors have that concern. But I think the PCAOB and the SEC staff have indicated that they will respect judgments that are made with proper due diligence and proper documentation. However, I don’t think that auditors believe that completely yet.

CPAJ: Why not?
Herz: I hear lots of descriptions of situations from both companies and auditors. The companies or the auditors will contend that a ruling or other decision by the SEC or the PCAOB regarding the application of a standard was unfair; yet when one asks questions about the specific facts of a situation that may have been the subject of a SEC or PCAOB action, you find that it was quite fair.

Corporate Governance

CPAJ: In light of the recent issues regarding stock options, such as “spring-loading,” which entails setting the grant date and exercise price of an option shortly before the company expects to announce positive corporate news, or “backdating” executive stock options after the price has risen—what can FASB do to mitigate this problem going forward?
Herz: Those are problems of corporate governance and basic dishonesty.

CPAJ: But the SEC has said that it doesn’t perceive spring-loading to be fraudulent.
Herz: I’m not an attorney, so I can’t make judgments on whether spring-loading is fraudulent. Probably, disclosures should have been made by the companies involved. As an investor, I’d like to know whether company executives are taking advantage of inside information for their own benefit. FASB passed SFAS 123(R) [Share-Based Payment], and we fought hard for that standard because it establishes the accounting for compensation that needs to be reported. From what I’ve heard, SFAS 123(R) has been effective in increasing disclosures. The SEC has also increased its disclosure requirements involving executive compensation.

CPAJ: To expand on that, the NYSSCPA’s Auditing Standards and Procedures Committee has discussed whether there should be internal control requirements for a corporation’s board of directors, because it serves as the head of the corporate governance structure. What do you think of that?
Herz: I’m not a corporate governance expert. But a company’s directors represent the shareholders, and if I’m a shareholder and I find out, after the fact, that without disclosure or due consideration, executives have been loading themselves up with equity awards and backdating them or just timing the awards to maximize their personal profit, that would be problematic. The real issue is the need for corporate boards to function properly. Whether a board’s conduct ought to be monitored, I can’t judge. But if you’re a director, you have responsibilities to the shareholders.

Fair Value

CPAJ: Fair value has presented some confusion and controversy within the accounting community. Do you foresee any additional guidance or changes with regard to the new standard, enacted in September 2006?
Herz: First, SFAS 157 [Fair Value Measurements] did not introduce the concept of fair value. The words “fair value” were already in many standards that go back 40 or 50 years. Some of those standards provided a definition of fair value and explained how to arrive at it, but each standard was different. Some standards gave no definition or explanation—they just used the words “fair value” as if everyone had the same understanding of what that meant.

In some cases fair value became almost a synonym for “not historical cost.” We felt it was important for consistency and from an educational perspective to create a new kind of standard—a reference standard—that said, “When we say ‘fair value’ in existing and future standards, here’s what we mean.” The standard provides a consistent definition and provides a framework for those measurements. The extent to which FASB requires or permits the use of fair value in the future is a different issue and will be addressed standard by standard when we look at a particular topic. Therefore, SFAS 157 is not introducing new fair value measurements—it’s just aimed at consistency, education, and providing a framework for what we mean and how to approach it. FASB has been dealing with implementation questions, and we have recently established a valuation resource group to help us provide further guidance in this area.

SFAS 157 also introduced disclosures intended to tell people when fair value was used and its impact on the balance sheet and the income statement. These disclosures also describe how the fair value measures were developed, such as stock-market price quotations from the newspaper, or measurements that involve more complex information, input, and valuation approaches.

CPAJ: Some would ask, “Why remove historical costs from the financial statements and not just supplement the historical financials with needed disclosures or a supplementary schedule that shows fair value?” That way users could find the information that is most helpful to them without being misled by unscrupulous executives who might use fair value accounting to manipulate a company’s financial picture. Why not say, “This is the standard. If you’d like to provide additional information, fine”?
Herz: Of course, the emphasis should be on providing useful information to those who read financial statements, including those who use them to make investment and credit decisions. The debate about fair value versus historical costs has, in my view, been somewhat misplaced because it’s not necessarily an “either/or.” One approach, which you suggested, is supplementary. Other approaches, which are based on economic theory and our conceptual framework, tell you that both fair value and historical costs can be accommodated within one accounting model. Among other goals, our very important project on financial statement presentation with the International Accounting Standards Board (IASB) is looking at that.

You might also want to look at the CFA Institute’s comprehensive business reporting model report [
www.cfainstitute.org/centre/cmp/BusinessReportingModel.html]. In today’s “mixed attribute” accounting, people are asked to make many estimates that are highly subjective, like depreciable lives of fixed assets, or impairment charges or loan-loss reserves. When you use a value-based approach, some other questions arise. For example, how to disaggregate and display the components of the changes in value. You could, for example, separately show the cash component, any working-capital accrual adjustments, and other elements of the change in value, so that users would be able to understand the various economic aspects that contributed to the change in value.

CPAJ: Why do you think there has been so much resistance to moving away from historical cost for accounting standards?
Herz: In traditional accounting, historical cost is the starting point, but then we have other highly subjective estimates, such as percentage of completion, loan-loss reserves, and deferred-tax assets. The SEC has something called critical accounting estimates that companies disclose. While one of those might be related to fair-value items, the rest are related to traditional historical cost accounting. I’m not necessarily plugging fair value, but I would like an objective and thorough discussion about its pros and cons as compared to other measurement attributes.

In that regard, an important part of our conceptual framework project with the IASB relates to measurement. We started open discussions on the subject by holding public roundtables earlier this year in Hong Kong, London, and the United States. The objective was to discuss the issue in general: why different measurement attributes, including historical cost and fair value approaches, are used.

Earlier you mentioned manipulation. People who don’t like fair value accounting usually cite Enron as a reason. Enron is an example of what I’ll call “unfair value,” using “mark-to-model” accounting without further adjustments to properly reflect fair value. When we were developing Statement 157, we asked investment portfolio managers and financial analysts—who follow derivatives dealers and companies that handle energy trading—if they preferred to know the historical costs or the fair value, with disclosures. They overwhelmingly chose the latter—fair value with additional disclosure.

Communicating with Users

CPAJ: Does SFAS 158 [Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans] “improve” information provided to financial statement users?
Herz: I hope so. SFAS 158 puts the plan sponsor’s position with regard to underfunding, or overfunding, squarely on the face of the balance sheet. When we asked users about this, they said they view underfunded plans as a liability. They also say they found the existing footnotes hard to decipher. A lot of users also told us the smoothing approaches under current pension and OPEB accounting in the income statement is, to quote one user, “public enemy No. 1.”

There are other big issues regarding cash balance plans because the traditional defined-benefit plan increasingly has been phased out or replaced by cash balance plans that offer lump-sum payments. From the participants’ perspective they resemble a defined contribution account or a 401(k), but under the law, they work more like a defined-benefit plan. Some believe that the measurement of these plans has been problematic, so that’s something we may also address.

CPAJ: How is FASB communicating its financial reporting initiatives to users, preparers, and auditors?
Herz: We have many formal and informal advisory and liaison groups whom we meet with and communicate with regularly. We also communicate with constituents through our documents, asking for and receiving comment letters, and by hosting public roundtables. We also do this through our website and written alerts and publications. Furthermore, because the financial reporting arena has become so high-profile, FASB receives endless requests for public speaking, and we accommodate as many as we can. Within the last year, I estimate that board members and senior staff spoke at more than 200 events.

CPAJ: Does that place even greater demands on FASB board members and staff?
Herz: It’s a balancing act. We view speaking events as an opportunity to inform people about what we are doing and to receive valuable input from constituents. Yes, the demands on the board are probably greater than they’ve ever been, but the demands on the reporting system are greater too.

CPAJ: There seems to be an insatiable quest for more input from stakeholders. FASB formed a new committee—the Investors Technical Advisory Committee (ITAC). How does its charge differ from the User Advisory Council (UAC), which FASB established in 2003?
Herz: The UAC, which consists of senior representatives of the investment community, operates at a high level in terms of providing advice to us on our overall priorities, direction, and dealing with major GAAP issues. Although we hope the ITAC group will also address some of those areas, the ITAC members were selected from people who satisfy two specific criteria: 1) they work in the investment arena full-time, which is true of the UAC too; and 2) they have significant experience, expertise, and focus on financial reporting, so their charge is to provide us with input and help at a more technical level.

CPAJ: Is that “hands-on” experience?
Herz: Yes, and I think the view was that we needed a group on the investor side like that. FASB hears from and meets with audit firms, state CPA societies, and the AICPA. At a technical level, we also hear from individual companies through their CFOs, controllers, and directors of financial reporting—both individually and through their industry organizations. We hear from accounting committees with Financial Executives International (FEI) and the Institute of Management Accountants (IMA), and we meet individually with many industry accounting committees. We felt that it was important to hear from the user community at a technical level as well. The best way to do that was to create a group like the ITAC.

The Profession

CPAJ: What role do you think professional societies can or should play in the accounting environment today?
Herz: Professional organizations are absolutely essential. We are certified public accountants, and our responsibility goes beyond figuring how to make more money for ourselves. Making more money is a good thing, but our primary responsibility is to the public. In my view, that needs to be a hallmark of our profession. The public believes that we provide a public service. We must live up to that expectation. The state societies and the AICPA provide important, knowledgeable input about the profession to the public and to agencies like the SEC and the PCAOB.

CPAJ: What are your thoughts on mobility within the profession—the ability for licensed CPAs to practice across state lines?
Herz: I’ve long thought that there should be a uniform national licensing, at least for activities like auditing public companies. I think the fact that we have a uniform CPA exam is very important. I remember the licensing issues from my days with the New York City office of Pricewater-houseCoopers, when we had clients in New Jersey, New York, and Connecticut, which meant our auditors needed licenses in all three states. I’m not sure different state rules and regulations are necessary. I think a uniform set of licensing rules should be worked out and applied at least to those activities that are clearly cross-state in nature.

Convergence and Codification

CPAJ: In 2003, The CPA Journal published your interview with then–editor-in-chief Bob Colson about many of your plans at FASB. What accomplishments since then have presented the greatest challenges?
Herz: The change-management issues involved in things like trying to develop standards that are more principles-based, and a financial reporting system that is less complicated in general. The second-guessing environment that we talked about earlier may not be conducive to more principles-based standards and to different approaches to reporting information that better reflect economics and finance, which a lot of investors want. Because these counter-forces are at work, we have to temper the degree to which we introduce change into the system. We have held back on implementing some needed improvements because people can do only so much at a time and have a limited amount of resources available.

CPAJ: What are FASB’s timetables for comment periods?
Herz: The timetable depends on the issue involved. If the issue is a narrow one that affects only a limited group of people, it can be as short as 30 days. For a major, global topic, the comment period is often 90 to 120 days. We prefer to err on the side of setting longer comment periods, because both those who wish to comment and those of us at FASB have other things on which to focus at the same time.

CPAJ: FASB’s codification project will create a single, authoritative body of U.S. GAAP. The stated objective is to integrate and topically organize all relevant accounting guidance issued by U.S. standards setters (FASB, including the EITF; the SEC; and the AICPA). Will this codification supersede all existing standards?
Herz: Yes, FASB has undertaken to simplify standards in four ways: 1) to take greater ownership for standards-setting so we don’t have multiple groups promulgating standards that may conflict with or contradict each other; 2) to integrate this mass of accounting literature by subject into a single codification; 3) to address how standards are written, which gets back to the broader issue of the complexity of the whole system; and 4) to develop new standards, in conjunction with the IASB, that are both better and less complex in areas such as revenue recognition and lease accounting. We are also looking at ways to try to simplify the current complex set of rules on derivatives and hedging and on transfers of financial assets.

We’re attempting to do our part. I have been pushing for a high-level commission or panel to address what can be done to create a system that both provides more useful, transparent information and does it in a way that isn’t as complicated as what we have now.

In the meantime, we continue with our codification efforts and to write standards in a more principles-based, understandable way. The codification project is massive. We brought in 25 outside experts to work on it. When it’s done and as people use it for a year or so, the “real world” will tell us how well it works. After that input is incorporated, it will then be officially adopted to replace the original pronouncements. Our standards-setting process, going forward, will follow that new codified body of literature by amending, adding, or deleting sections of the codification. We hope that new body of literature will be much more usable for everyone.

CPAJ: What else would you like our readers to know about FASB’s efforts?
Herz: I want to re-emphasize FASB’s awareness of the importance of the pace of change; the openness, thoroughness, and deliberateness of FASB’s process, and how important the engagement of all points of view is to FASB’s work. FASB not only develops proposals and puts them out for public comment; it engages many different groups and viewpoints, using roundtables and visits to companies and constituents. When we give people the opportunity to comment, we learn. We deliberate using all of that input. It can be frustrating at points because the process is so involved, but it’s also very rich. We work hard to maintain a certain balance between timeliness and due process.

Another point that I would like to make is that during my tenure, FASB has tried to rationalize the accounting standard structure, to establish a structure that includes more direct responsibility for, and ownership of, standards setting.

CPAJ: If you were to create a map for the future, what’s your vision for FASB?
Herz: I believe strongly in international accounting-standards convergence, and I believe that creating common international standards in at least the public-company arena is very important. We are working hard and systematically with the IASB and others to bring about convergence, but it will take a number of years and I’m not sure we will fully get to the “promised land” during my tenure. However, I’ve been to the mountain, so to speak, and I can see convergence becoming a reality. In such a world, FASB’s role would change, but exactly how remains to be seen.