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June 1994

Accounting rule making - a two headed monster?

by Poteau, Raymond R.

    Abstract- There has been a long-running power struggle between the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) over their role as financial accounting standard-setters. Since both boards have the authority to establish generally-accepted accounting principles, conflict arises when they provide different answers to the same questions. The ideal solution to the problem of different accounting standards for similar transactions is to integrate all rule-making bodies into a single organization with a separate accounting staff for commercial entities, state and local governments, and the federal government. Unfortunately, this solution will never be accepted by organizations, institutions and politicians who want to stay in control. The best alternative would be for the Financial Accounting Foundation to exert its influence over the FASB and GASB so that their operations will be coordinated.

Both the FASB and GASB can establish GAAP. The dilemma arises when both bodies give different answers to the same question. Here's why we have this problem, with some examples, and a possible solution.

The Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) have been involved in heated debates over their role in setting financial accounting standards. Much of the debate has centered on questions of politics and constituencies. The FASB has been subjected to furious criticism from the business community because of the FASB's alleged lack of sensitivity to the concerns of those that must implement financial accounting standards. The most recent example of this is the proposal for accounting recognition of the value of stock options issued as compensation. The GASB has been caught in the middle in a struggle between the Financial Accounting Foundation (FAF) and organizations well entrenched in the governmental financial reporting community.

The problems of politics and constituencies will never go away, and both the FASB and the GASB will continue to struggle with these realities. Hopefully, the battle for power and influence will have a positive effect on the processes used to establish GAAP. However, there is a more subtle problem beginning to surface that we believe will eventually weaken the roles of both the FASB and the GASB if the problem is not identified and addressed quickly. The problem arises from the very structure used to promulgate GAAP and raises the following question: Because two authoritative bodies are now empowered to establish GAAP, will that structure create dissimilar accounting and reporting standards for similar transactions and events?

The identification of the problem will be made more real by carefully reviewing recent standards set by the FASB and the GASB for the same accounting issue. The analysis will demonstrate that the FASB and the GASB are promulgating dissimilar accounting standards for similar transactions and events.

Origin of the Problem

For years the debate has raged over whether a single organization should be the sole promulgator of GAAP. After considerable debate, in 1984 the FAF and various representatives from the governmental financial reporting community agreed the GASB should be created along the same lines as the FASB and assigned the role of promulgating accounting principles for governmental entities. The Auditing Standards Board (ASB) acknowledged the existence of the GASB by issuing an interpretation of SAS No. 5 in 1984 and eventually amended its hierarchy of sources of accounting principles through the issuance of SAS No. 52 in 1988 as follows:

A. FASB statements and interpretations, APB opinions, AICPA accounting research bulletins, and, for state and local governments, GASB statements and interpretations.

B. AICPA industry audit and accounting guides, AICPA statements of position, and technical bulletins issued by the FASB and GASB.

C. AICPA accounting interpretations, as well as practices that are widely recognized and prevalent in the industry.

D. Other accounting literature.

While the hierarchy clearly established the authority of the GASB, it also created a monstrous problem. That is, if the GASB had not addressed an accounting issue but the FASB had, the promulgation issued by the FASB would have to be followed when preparing financial statements of governmental entities. This flaw in the accounting hierarchy forced the GASB to adopt a negative-standards approach, meaning the GASB had to issue statements that concluded specific standards recently issued by the FASB would not have to be followed by governmental entities. For example, SFAS No. 87, Employers' Accounting for Pensions, was issued by the FASB to establish measurement and display standards related to pension plans. Shortly thereafter, the GASB issued GASB No. 4, Applicability of FASB Statement No. 87, "Employers' Accounting for Pensions," to State and Local Governmental Employers, which concluded the standards established by SFAS No. 87 did not have to be followed by governmental entities.

If the GASB was to control its own agenda, it was evident the hierarchy would have to be changed. This was accomplished with the issuance by the ASB of SAS No. 69, which established a separate hierarchy for governmental accounting as follows:

A. GASB statements, GASB interpretations, and FASB and AICPA pronouncements made applicable by a GASB statement or GASB interpretation

B. GASB technical bulletins, AICPA industry audit and accounting guides and statements of position that have been made applicable by the AICPA and cleared by the GASB

C. GASB emerging issues task force consensus positions (if created) and AICPA AcSEC practice bulletins that have been made applicable by the AICPA and cleared by the GASB

D. GASB implementation guides and practices widely recognized and prevalent

E. Other accounting literature, such as GASB concepts statements, sources identified in Categories A through D in the private-sector accounting hierarchy that have not been made applicable by action of the GASB or AICPA, APB statements, FASB concept statements, AICPA issues papers, international accounting standards committee statements, pronouncements of other professional associations or regulatory agencies, AICPA technical practice aids, and accounting textbooks, handbooks and articles.

While solving one problem, SAS No. 69 (which was based on a proposal by the FAF) created a subtle but more troubling problem. Now the GASB is basically free to construct its solutions to perceived financial reporting problems without being too concerned with positions taken by the FASB.

Broad Nature of The Problem

Does the existence of two rule-making boards create a problem? Clearly the answer is "no" if the transactions and events that affect governmental entities are uniformly different from transactions and events experienced by commercial entities. There is no doubt governmental entities do experience transactions and events not experienced by commercial entities (and vice versa). For example, state and local governments have the power to tax their citizens and certain activities conducted within their boundaries, and the unique character of the taxing authority requires criteria be established for the recognition of tax revenue.

Although there are transactions and events unique to a governmental entity and a commercial entity, there are many similar transactions and events that affect both entities economically in the same manner. For example, both entities pay employees and vendors for services rendered. Both entities enter into long-term contracts with similar legal commitments. Both governmental and commercial entities execute lease agreements, enter into pension agreements, and commit to the payment of various fringe benefits other than pension payments.

Logically, similar transactions and events for all entities should be subject to similar accounting standards. This does not mean the application of the standards creates the same results. The measurement focus (what transactions and events should be reported) for commercial entities is different from the measurement focus for (non-proprietary) governmental entities. For example, long-term liabilities are presented as a balance sheet item for a commercial entity but are reported as part of an accounting group (General Long-Term Debt Account Group) by a (nonproprietary) governmental entity. Although many argue all entities should use the same measurement focus, even with different measurement focuses the same standards (with some implementation guidance) could be applied to similar transactions and events.

The existence of similar transactions and events for all entities does not preordain the establishment of two sets of different accounting standards. However, common sense will strongly suggest that is exactly what is going to happen. Members of the FASB and the GASB are highly competent and both have separate professional staffs to carry out their missions. It is almost inconceivable that the two independent bodies would look at the same accounting issue and develop the same accounting and reporting standards to address that issue.

From the above argument, should we conclude the organizational relationship between the FASB and the GASB is flawed and therefore should be scrapped? Closer analysis strongly suggests there is a "real" flaw in the rule-making structure and the profession needs to act appropriately to prevent the flaw from developing into a fatal crack in the process.

The Specific Nature of the Problem

Insight into the problem of two existing rule-making bodies can be gained by examining accounting issues common to commercial and governmental entities alike.

Cash Flows. Over the past several years there has been a heightened interest in cash flow analysis. In 1987, the FASB reacted to the demand for cash flow information by issuing SFAS No. 95, Statement of Cash Flows. Two years later, the GASB issued GASB No. 9, Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds and Governmental Entities That Use Proprietary Fund Accounting.

The objective of a statement of cash flows was described as follows in SFAS No. 95:

The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period.

GASB No. 9 established the same objective except the word entity was substituted for enterprise.

Few would disagree with the basic objective defined above and it is important to recognize both the FASB and the GASB started at the same point in addressing the accounting issue. That is, both identified the primary objective and then proceeded to establish specific recommendations to achieve that objective. Different standards, however, were established to resolve similar problems.

The most significant difference between SFAS No. 95 and GASB No. 9 format. SFAS No. 95 requires three major categories of cash flow activities, namely operating, investing, and financing. The GASB decided four categories (operating, investing, noncapital financing, and capital and related financing) should be used by governmental entities that use proprietary fund accounting. Proprietary fund accounting is used for funds that engage in activities similar to commercial entities.)

Although it appears the addition of another category by GASB No. 9 is simply an attempt to differentiate between financing activities, the difference is far more.

GASB No. 9 requires capital asset acquisitions, improvements, and construction be classified as capital and related financing activities. SFAS No. 95 requires these transactions be considered investing activities. The addition and composition of a fourth category should be applauded if that category is based on transactions and events unique to governmental entities. That is not the case. Public as well as private entities acquire capital assets and those acquisitions are often financed from external sources. These transactions are the same, yet the GASB has established different presentation requirements.

The GASB's argument for the fourth category is based on the assertion governmental entities should make a clear distinction between financing and managing cash flows related to operating activities and those related to capital activities. The GASB attempts to support this argument by noting governmental entities have separate capital budgeting and long-range capital planning. To suggest that private entities do not differentiate between financing operations and capital programs is difficult to understand. An entity that does not understand the difference between cash flow financing and management for capital projects is an entity headed for significant financial problems.

The point is not that a fourth category should not have been added by the GASB. Perhaps there should be a fourth category. There is no argument, however, that will stand up to analysis suggesting government entities using proprietary accounting are so unique the fourth category is obviously needed. The difference arises not out of the difference between the nature of transactions and events, but because two separate bodies are free to weave what each sincerely believes is the best solution to an accounting issue.

GASB Statement No. 20. This recently issued statement, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting, will surely add to the confusion. Governmental entities applying business-type accounting and financial reporting are required to apply all applicable GASB pronouncements and those FASB statements and interpretations, APB opinions, and ARBs that were issued on or before November 30, 1989, that do not conflict with or contradict a GASB pronouncement. However, these organizations have a choice to make regarding FASB pronouncements issued after November 30, 1989. They may choose to apply all of them--provided they do not conflict with a GASB pronouncement--or not to apply any of them.

By a stroke of GASB's pen, they have created a two-headed monster within governmental accounting. The result will be a third head to further confuse investors and creditors. SAS 69 was supposed to clarify jurisdictional matters among the two standard setters and presumably among users of financial information. The result seems to have been the complete opposite.

Debt Refundings. GASB has done it again with its recent approval of a statement on the way state and local governments account for current refundings and advance refundings that result in defeasance of debt reported by proprietary activities. The statement will require that the difference between the reacquisition price and the net carrying amount of the debt be deferred and amortized as a component of interest expense over the life of either the old or new debt, whichever is shorter.

This approach is a complete departure from the FASB pronouncement on refundings that requires that the difference be treated as an extraordinary gain or loss. While the FASB approach seems to make no sense at times--an economic gain ends up being recognized as an accounting loss--any thought of comparability between the two sectors is becoming seriously eroded.

Does It Really Matter?

Some may argue the two domains are sufficiently separate that two different sets of rules for similar transactions and events are acceptable and perhaps to be expected. The authors do not accept that position. For example, would potential creditors make optimal credit decisions when two different sets of accounting standards are applied to similar economic events for enterprises competing for limited resources?

The comparability concept would be diminished on several levels in financial reporting if both boards continue to establish dissimilar accounting standards for similar transactions and events.

Comparability is an important concept in financial reporting whether that concept is applied on a broad basis or at the individual firm level. Society needs to compare activities of different entities to determine whether those activities are efficient and effective. Fundamentally, we as a society must decide whether activities are better placed in the public or private sector. We have just completed a decade in which the question of privatization has been debated and applied. Reaching the best solution in assigning activities to the public or private sector is dependent to a great deal on the quality of financial information used to analyze specific activities.

Moving from the broad social issues, comparability is damaged at the point where similar activities are carried on by private and public entities. Generally in the public sector, these activities are accounted for in proprietary funds (usually enterprise funds but to a lesser extent, internal service funds). For example, water treatment services are provided by public entities as well as private entities. Private sector entities must observe standards established by the FASB while public sector entities must look to the GASB for guidance in preparing their financial statements.

For clearly similar activities provided by private and public entities, the comparability concept is very important. The financial statements (along with other financial and nonfinancial information) would be an important base for determining the success of a particular entity; however, if the reporting standards are different, comparing activities becomes difficult and in some cases meaningless. To return to the cash flow example discussed earlier, it is very possible a public water treatment entity could report a positive cash flow from operations based on the standards established in GASB No. 9 and that same entity could recast its statement of cash flows under FASB No. 95 and report a negative cash flow from operations. This is true because of the different treatment of interest payments on debt and cash flows from investment income.

If we move from activities performed by private- and public-sector entities to a specific industry, the comparability concept becomes even more pronounced. Recently there was a fierce debate over whether colleges and universities should follow standards established by the FASB or the GASB. Based on recent action taken by the FAF, private colleges and universities will follow FASB reporting standards, and public colleges and universities will follow standards established by the GASB. The industry is very upset with this action because financial reporting comparability within the industry will be lost. For example, private colleges and universities must record depreciation while public colleges and universities are under no such mandate. According to a financial officer of a large private university, "We will not be able to talk with other financial professionals in the public university (across town) because we will not understand their financial statements."

Is this what accounting rule-making is all about?

How to Mitigate the Problem

The comparability issue is already a very real problem in financial reporting and it will get worse based on the current structure for establishing accounting standards.

What can the profession do about it? In an ideal world, we would simply merge all rule-making authority into a single body that would have an accounting staff that has expertise in financial reporting for private entities, state and local governments, and the national government. This is not going to happen. Organizations, institutions and politicians are not going to lose control of a process that has an effect on their ability to attract and expend resources. All parties recognize the first step in establishing accountability is establishing a meaningful system of accounts.

Perhaps the only viable solution at this point is to urge the FAF to exercise its mandated control over the FASB and the GASB so their actions are coordinated and proposed differences in accounting standards are exposed to critical analysis of the highest order. Simply put, the standard to be enforced by the FAF would be: similar transactions and events must be accounted for in a similar manner.

Larry P. Bailey, PhD, CPA, is professor of accounting at Rider University in Lawrenceville, New Jersey. Raymond R. Poteau, MBA, CPA, is Dean of the School of Business and associate professor of accounting at Philadelphia College of Textiles and Science in Philadelphia, Pennsylvania.

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