FASB chairman Robert Herz: 'complexity impedes transparency'.

Robert H. Herz, Financial Accounting Standards Board (FASB) chairman, recently spoke with Financial Executive's Executive Editor, Ellen M. Heffes, on a variety of subjects. These included convergence, International Financial Reporting Standards (IFRS), FASB standard-setting, smaller public and private companies and Herz's "pet" subject, complexity. Some of his comments follow. For the complete text of his comments, and a review of current FASB projects, go to www.fei.org/mag/articles/11-2005_fr.cfm.

Heffes: Let's start with a "pet" subject of yours: complexity. Talk about complexity.

Herz: I have been very vocal about it and will continue to be very vocal about it. Our system, in my view, is not only too complex, but it's a complexity that impedes transparency. We've been trying to do some things on our part towards simplification, including our major codification project.

We are also trying to make our standards more understandable and readable, but I will tell you that there are powerful forces at work in the reporting system that continue to cause complexity and reduce the understandability and overall usefulness of reported financial information. These involve some fairly embedded cultural, behavioral, institutional and structural issues in the system.

For example, we continue to get a constant flow of demands for detailed rules, bright lines and "safe harbors" that are prompted by the fear of second guessing and litigation. We see a mentality that avoids the exercise of professional judgment, which makes it very difficult to move to a more principles-based system.

We also get regular requests by individual companies and industry groups for special exceptions and special accounting treatments, and we continue to see (although less of them, but I think the Securities and Exchange Commission (SEC) continues to see) the use of purely accounting-motivated transactions to burnish reported financial results.

So, we're trying to do our part to reduce complexity, but my message is that this is something beyond just the FASB or even the SEC. It's an issue that I think all parties need to get together and say. "How are we going to deal with this complexity problem?"

But different people see the problem differently. For their part, preparers are understandably frustrated over the cost and effort of trying to understand and follow the myriad of standards, rules and regulations, costs of training and implementation, disclosure overload and the potentially high cost of inadvertent misapplication. That's one of the reasons why we're putting together the codification, to get this beast under control.

On the other hand, users of financial information express frustration over the analytical complexity and lack of transparency associated with a system that sometimes reports similar items using different measurement approaches, permits all sorts of elections and off-balance sheet treatments and otherwise masks transparent reporting of performance and financial condition.

So, I believe we all need to collaborately find a way out of this box if we are to reduce complexity and continue to improve the relevance and usefulness of reported financial information.

Heffes: You must be pleased with the progress of the convergence project. Also, the FASB and International Accounting Standards Board (IASB) recently released joint Exposure Drafts. Talk about the experience, the feedback you're receiving and your expectations. By press time, the October roundtables will be over.

Herz: I do feel good about the convergence effort. We've been working well with our counterparts at the IASB. We've designed good processes and we're systematically trying to follow those. Getting agreement on key issues is not always easy, so we have to be very thorough and committed to going through the process together.

We released two companion Exposure Drafts together--one on business combinations and one on what we call "non-controlling interests," which most people know as "minority interests." Getting to the point of having a 98 percent common exposure draft is an accomplishment, because we always have people with different views, and the IASB is comprised of board members from all over the world.

We've gotten some letters, but I think most of the letters are yet to come in. The preliminary indications are that most preparers have concerns over a number of the provisions. On the other hand, we've met with the financial reporting committee of the CFA Institute (Chartered Financial Analyst) and with other users of financial information who were very laudatory.

We will carefully analyze all the letters; we will hold public roundtables. Roundtables can be very useful because they provide for dialogue between different parties on the issues. We'll then analyze all the issues and the comment letters and go to redeliberations, where we carefully go back through the key issues.

It's a process that works, and the fact that we could get to this stage on a major topic of a joint set of exposure drafts augurs well for the future.

There's another important point: whether or not particular readers like the accounting approaches in the exposure drafts. I'd ask them to focus also on the style of the documents because they are written more in the international style, with black-line principles followed by discussion and explanations and lots of examples. So, I know there will be some people who don't agree with particular aspects of the proposal, but we'd also like feedback on the way they have been written and presented.

Heffes: What do you see as the next step in the convergence process?

Herz: To me, convergence is both a process and a destination, and we're going to continue the process towards that destination. We are working together already on a number of other joint projects [such as] revenue recognition, reporting on financial performance, improving and merging our conceptual frameworks. We are doing work on liabilities and equity, and when we get to a [certain] point, the IASB will join in. They're doing work on insurance, and if they can develop something that looks promising, we will probably join in on that.

Then there are a number of other future projects--major areas where we believe that financial reporting needs improvement in both U.S. standards and international standards. We will likely work together on those; areas like pensions and other post-retirement benefits, leasing, consolidation and financial instruments.

We will also continue, but not in a big way, where there are areas where we've got more targeted differences, and we think that there are relatively quick ways to converge; we will look to do that as well. We're working on some of those right now, like income taxes, where the principles of our respective accounting for income tax standards are very similar but they both contain some exceptions, but the exceptions are different. We're going through those exceptions systematically to figure out where either there should be no exceptions, or if we're going to have exceptions, let's have them converge.

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Heffes: So you think that the convergence project on income taxes might be the next exposure draft that comes out between both FASB and IASB?

Herz: I think that could be the next one, next year. It would be a little different. In other words, we would both propose changes to our existing standards to get to the same place.

So it wouldn't actually be a common exposure draft, because let's say there are six exceptions in their literature and six different exceptions in ours. Let's say we jointly decide that three of these exceptions are valid, and ought to be retained. We would put out an exposure draft that would propose eliminating three of our current exceptions and potentially change the other three. And they would put out an exposure draft that would eliminate three and potentially change some of their exceptions--because we're starting out with different exceptions and trying to get to the same place.

Heffes: A big part of the rest of the world has changed over to International Financial Reporting Standards (IFRS) for 2005 reporting. The last time we spoke, you expressed that it could be within seven to 10 years that we do reach convergence. Is that still on your radar--now in six to nine years?

Herz: First, I think what's going on in many other parts of the world in adopting IFRS is one of the most monumental efforts and events in the history of accounting and financial reporting. Think about it. To be sure, we've gone through a lot of change here with our Sarbanes-Oxley Section 404, and other things, but just think about other parts of the world where they're changing completely, from their national GAAPs to a very different form of standards all at once. It's mind-boggling!

We, obviously, very much support that effort. We think it's a good thing. Will there be completely smooth and flawless implementation the first time around? I doubt it. Like [with] 404, you've got to expect some issues coming out of it; but those will be dealt with, and it's a process of continuous improvement.

I continue to believe that time frame for convergence is realistic. Convergence, as I said, is a process and a destination. The ultimate destination of there being completely converged standards is basically to get to one set of standards. I believe that it is feasible within nine years. I believe there will be substantial convergence in many major areas before that, though.

Heffes: On differential standards: The SEC is showing a lot of sensitivity to smaller public companies for reporting deadlines and more. And, FASB created an advisory board for smaller companies, both public and private. Where does this stand?

Herz: We've done a number of things in the last few years. We did create a small business advisory council, which consists of preparers, auditors and users from both small public companies and many who are involved with private companies. We also have put a private company preparer and a private company auditor on the Emerging Issues Task Force (EITF), and in some of our recent standards we very much focused on small and private companies, both in effective dates and even in methodology.

For example, in 123(R), Share-Based Payments, we provided for a simplified method for private companies to calculate stock option valuations. We provided for delayed effective dates both for private companies and SEC small business issuers after discussing that with the SEC.

The American Institute of Certified Public Accountants (AICPA) did some work last year on private company reporting, and recommended that it needed a more intense look and [that] there be processes put in place to do that. We have been actively engaged in discussions with AICPA and others on how best we can improve our processes. We continue those discussions and to the extent we believe that process changes might be in order, we will publicly expose any proposals for comment.

My own view, is that it is very important for us to continue to focus on the needs of the small and private companies. There may be differences [and] different needs amongst the users of private companies, who are often primarily lenders and creditors. And, of course, there are also sometimes important cost-benefit considerations.