For FASB's Herz: 'the ultimate destination--a single set of common standards'.

As noted in an article for this column in 2002 introducing then-new Financial Accounting Standards Board Chairman Robert H. Herz, he was "beginning this high-visibility post at a turbulent time for accounting standard-setting." That was just after Enron's collapse, and prior to the Sarbanes-Oxley Act of 2002.

Fast-forward five years, and although we're past the accounting scandals that rocked the business world and investor confidence, many other issues have converged that keep the climate turbulent and the stakes perhaps even higher.

As he begins his second term, Herz again spoke with Financial Executive Executive Editor Ellen M. Heffes about then, now and, importantly, the future for three areas of concern to FEI members: competitiveness, complexity and convergence.

Herz was appointed in April 2002 and arrived on the scene that July--just days after WorldCom made headlines and Sarbanes-Oxley was yet to be signed (on July 30). His chairmanship started "when the financial reporting system was very much in question and under a lot of scrutiny, and when there was a big need to plug some holes in some areas that were revealed by Enron and some of the other reporting scandals," he recalls. Also, as Sarbanes-Oxley unfolded, preparers and auditors were experiencing increased activity and stress implementing Section 404.

Despite the obstacles, Herz points to a number of achievements. Internally, he says, three strategic objectives were set: improvement, simplification and convergence. The first involved improving the accounting literature (particularly in areas where it was believed it wasn't doing the job). These included special-purpose entities, hidden guarantees, share-based payments (including expensing stock options), the first stage of pension accounting, providing a framework around fair value measurements and several other projects that FASB has taken on, including the Codification Project, which is close to being released for public use. FASB is reorganizing, restructuring and standardizing disparate literature by subject matter, so that everything on a topic will reside in one place.

Simplification involves trying to move to one accounting standard-setter or to rationalize the standard-setting structure in the U.S., "so that there wasn't literature coming fast and furious from multiple sources"--including the U.S. Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants (AICPA)--but rather that it would mainly come from FASB.

Third, international convergence was launched with the Norwalk Agreement shortly after Herz arrived. Over the past few years, FASB and the International Accounting Standards Board (IASB) have been working very closely together on joint projects to bring about both improvement and convergence.

Staff was increased from about 55 to 70, and other internal process improvements were made. For example, previously, certain documents containing authoritative guidance, including Emerging Issue Task Force consensuses, did not go out for public comment. All that is now happening. And Herz proudly points to FASB's website, which now hosts all of the organization's literature, allowing easy access.

Herz has also enhanced the use of advisory groups and created new ones, such as the User Advisory Council, the Investor Task Force, the Investor Technical Accounting Committee and advisory committees on financial reporting by small and private companies. While good input and participation was provided by preparers, the auditors and the AICPA, he says, "Previously, we heard less from investors, and in the post-Sarbanes-Oxley era, it was clearly important that they have a good say in our process as well."

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So, on which side of the "are rules and regulations driving capital away from U.S. markets" argument is Herz? Having read the so called "Paulson Committee," U.S. Chamber of Commerce and the Bloomberg-Schumer studies, as well as many other pieces that have been put out by investor groups that say that those people have it wrong--and having been a participant in Secretary Paulson's Georgetown University gathering on the subject last March--Herz concedes it's a "fairly complicated subject."

He emphasizes that the capital markets are globalizing. Ten years ago, if an American or foreign company wanted to raise billions of dollars in new capital, there was only one place to go--the U.S. That is no longer the case, as there are other strong, viable capital markets. "We do have competition," he says; however, "the U.S. is still regarded by most investors as the highest quality."

Herz acknowledges, "There are more stringent requirements here, there is more enforcement, the legal environment is often cited as something that people would rather not deal with and people also note that the underwriting costs for raising capital are about double."

Much discussion at the Paulson meeting, he says, centered around overall competitive issues, principles versus rules and the connection--not so much with accounting standards or financial reporting, but rather with our regulatory and legal system. The U.S. has federal agencies, state agencies, state attorneys general, etc., that can create a somewhat confusing and daunting environment for companies. On the other hand, investors said they were interested in rigorous enforcement and think that some of that overlap is good.

Herz says his takeaways are that the U.S. is not the sole capital market anymore for raising meaningful money, meaning we do need to think about our competitiveness and potentially changing aspects of our system, but we want to maintain a reputation for quality and safety of investments. Thus, he warns, "We should not engage in a race to the bottom."

Complexity, Convergence

On progress in complexity and readability of financial statements, Herz argues that "complexity means different things to different people." As a preparer, it's figuring out what you're supposed to do; doing it--including putting in the systems, training people and gathering the needed data; and then worrying about whether you're going to be second-guessed. For the auditors, it's similar.

For investors, he says, it's an issue of transparency and getting enough information to do forecasting and decide where to invest money. Investors are trying to figure out what was done in the financial statements and their relationship to reality. Why are there all sorts of options and alternative methods in accounting? Are the company disclosures full and honest? Can I figure out what they're really saying, or is it just couched in legalese? Are they hiding things from me?

Other readability problems arise from standards that run into hundreds of pages--including the 30-or 40-page standard along with lengthy implementation guidance with examples, a thorough basis for conclusions and amendments to the existing literature. The length of the documents is due, in part, says Herz, to "people in our country [who] like examples, and who have often looked for 'build-to-suit accounting.'" He attributes this industry-specialized accounting largely to the accounting profession and preparer industry groups. The resulting system, he says, "was created with good intentions, but has significantly added to the overall volume and complexity of U.S. GAAP [generally accepted accounting principles]."

FASB is working on this on several fronts. By way of simplification, FASB has tried to stop "as best we can," standards and different pieces of literature coming from different sources. As mentioned earlier, the codification project aims to consolidate all the literature on a given topic, in a structured way.

Also, he notes FASB is trying to replace some of the existing literature that's extremely detailed and rules-based with something that is closer to economics and that will involve principles. In addition, it is working with IASB on strengthening the conceptual framework.

Finally, there is an understandability initiative underway. An exposure draft was recently issued on accounting for financial guarantee insurance, in a new format that was created by working with outside groups (including FEI members). It highlights the objectives and principles, explains them and contains examples right in the text, rather than just in a separate appendix. Herz encourages comments on whether people like this style.

For now, Herz believes this "may be about as far as we can go with our part of this conundrum." He reiterates what he's said in many speeches: that what we have in this country is going to require much broader, much more concerted action by everybody to acknowledge we have a problem and then to address it collectively. "[For] some behaviors, maybe some structural elements in the system need to change."

He believes "some companies want to control reported earnings, even though the world in which they operate is not completely controllable."

There are many interrelated pieces that need to be looked at, argues Herz, and that's why--starting about two years ago--he called for a national panel. He says it is pretty close to being set up.

Convergence

Much is happening in the area of convergence of U.S. GAAP and International Financial Reporting Standards (IFRS). What is the impact on U.S. GAAP, and what will it mean for FASB?

Herz says that two SEC activities this summer are key First, the SEC is expected to issue a proposal to drop the reconciliation requirement for foreign filers; the second is a concepts release, an early-stage document, asking for comments on whether U.S. companies should get a choice of using U.S. GAAP or IFRS.

He believes that since investing and M & A activities are not limited by national borders, "the ultimate destination has got to be a single set of high-quality common standards that are applied with a fair degree of consistency across the major capital markets of the world so that you get common financial information."

And, the best path to get there? He's fairly comfortable with dropping the reconciliation because he believes it's not used much. "The main benefit of having the reconciliation seems to be that it has been kind of a disciplining mechanism on foreign companies and their auditors, because most places don't have the regulatory review and enforcement regime that we have." It's revealed a number of unaddressed problems at the foreign local level, he says, but doesn't see that as enough of a reason to keep it. He believes that the emphasis ought to be more on the rigor of the audits and on the rigor of the regulatory process in those jurisdictions.

Another factor to consider is that if the SEC doesn't drop the reconciliation requirement, other parts of the world may impose a counter requirement on U.S. companies that are in their markets. "Trying to achieve a trade war by accounting reconciliations is kind of nonsense," argues Herz.

The discussion that needs to be had, he says, is on which way to go. If we believe in getting to one set of standards, then what's the best way to do that? Is it to allow the choice now, or does that have a negative impact? And what might be the cost, benefits and consequences of allowing two sets of accounting standards to be used in the U.S.?

An alternative might be to set a target date for moving our system to international standards and set some benchmarks of what needs to be done in the interim, which other parts of the world have done. "Europe [and] Canada have made tough decisions. Canada often used to model its standards after U.S. standards; now, assuming certain things happen, it will go to IFRS by 2011."

Herz doesn't expect either FASB or IASB to look the same in the not-too-distant future. Indeed, some have contemplated a FASB/IASB merger. "I don't know whether that would even be feasible or how it would work out," he says, but expects that to play out over the next three to five years.

Which now begs the question: in such a scenario, does Herz expect to complete his second five-year term as FASB chairman? All he'll say is that he plans as far as he can, long-term, for the organization. "However, the world also moves."

Stuck on GAAP?

How does he respond to those U.S. finance executives who are stuck on U.S. GAAP? Herz points to FASB's agenda and comments, "They need to understand that almost everything major we're doing now is with the IASB--virtually all of our major projects now are joint projects."

Constituents may believe they can influence things, which is somewhat true. Herz indicates FASB is working to eventually develop a common set of reporting standards; by 2009, it is expected the SEC will lift the reconciliation requirement, but achieving total convergence is going to take a lot longer. He cautions: "people really should start to get very engaged in this SEC process that's about to unfold. Those are important policy questions, the outcome of which is definitely going to affect them."

Along with convergence, could routine use of extensible Business Reporting Language (XBRL) also be in the cards? Herz says he's been a big backer of XBRL for a long time. "It's just generally using technology to improve the product. Most other products in the world are now driven by technology, but financial reporting's lagged behind."

He even co-authored a 2000 book, The ValueReporting Revolution: Moving Beyond the Earnings Game, in which the authors talked extensively about XBRL--then in its early stages--and how it could become an enabler of better reporting and greater ability to use that reported information.

SEC Chairman Christopher Cox is backing XBRL, and has dedicated money and a lot of political capital to promoting it. FASB and the Financial Accounting Foundation were very involved in organizing and beginning the effort to build out U.S. GAAP taxonomies, and then handed that off to XBRL U.S. Along with the SEC, FASB is now charged with reviewing and accepting what gets put out. The goal is that by sometime this fall, there will be a much more complete set of taxonomies for U.S. reporting. However, the SEC's voluntary program presently has only about 40 companies in it.

"[XBRL] will get built, but will they come?" asks Herz. "If they don't, will the SEC mandate it? I don't know."

Finally, what does Herz want to accomplish during his second term? "We're going to continue with our three strategic goals of improvement, simplification and convergence. And, in any major project, we like to achieve all three of those together." Looking out, he believes that with convergence and the possible use of IFRS in the U.S., along with addressing complexity and using XBRL, the U.S. may be on the cusp of very significant changes in its reporting system. "I view my role as helping to lead this organization through the changes and also to be a voice within the reporting system."

EDITOR'S NOTE: Robert Herz is a keynote speaker at FEI's Global Financial Reporting Convergence Conference, to be held in New York on September 28. Check the FEI website for details.