The FASB - suggestions to improve the process.

The FASB has devoted too much of its resources to the details of implementation, say some critics. Does it need to get back to conceptual issues?

Even though the Business Roundtable, Financial Executives Institute (FEI), and the Financial Accounting Foundation (FAF) have reviewed the accounting standard-setting process in the United States, in 1989 the Accounting Principles and Auditing Standards Committee of the California Society of Certified Public Accountants decided to do its own review. The FASB's frequent need to suspend or change recent pronouncements and the California Society's own difficulties in dealing with the process have led the group to believe that the standard-setting process is indeed in trouble. What follows is a review of the Committee's findings.

Of one thing the Committee is very certain: now is not the time for the FASB to go the way of its predecessors. The Board is making progress in the betterment of financial reporting. Perhaps more important, the FASB provides the basic foundation for retaining the standard-setting process in the private sector, which best serves the public's needs.

Symptoms of the problem:

The FASB's constituents have reason to question the effectiveness of its process:

* Pronouncements issued after the FASB and the profession spent several years in their development have been modified or deferred. The most obvious example is Statement of Financial Accounting Standard 96. Statements 98, 99, 100, 101, and 102 all changed or deferred prior pronouncements. We infer from these examples that problems in implementation are discovered only after a pronouncement is issued, a symptom of inadequate testing.

* The profession has had problems in implementing statements because of over-specification of details. The most obvious current examples are Statements 95 and 96; Statement 13 is an older example. The reduction of broad accounting principles to detailed instructions invites practitioners, the "sharpie" clients, and investment bankers to try to "beat" the rules, demonstrating the impossibility of writing rules that cover all details.

* There are inconsistencies between standards. For example, Statement 96 specifies nonrecognition of a deferred tax asset, but the recent pronouncement on other postemployment benefits calls for recognition of an asset to partially offset the liability. This inconsistency demonstrates that standards often do not adhere to overall concepts.

Standards versus guidance:

The Committee believes that the principal problem confronting the FASB is the blurred distinction between accounting standards and implementation guidance. Somewhere between writing the concepts and specifying implementation, the FASB and its staff lose the way.

Accounting standards should consist of the common body of knowledge against which all transactions are measured and accounted for. To enable their consistent application across entities and industries, standards must be conceptual. But most of the FASB's current standards attempt to include both a concept and specific guidance for implementation. Further, much of the implementation guidance included in these standards is of the "you-can't-step-across-this-line" school-the cookbook approach.

As an important first step, the FASB needs to clarify the distinction between standards and guidance, and to focus its efforts on setting concepts. It needs to remove those portions of existing statements that represent implementation guidance and identify them as guidance, and to combine those elements of existing statements that are conceptual with the current statements of financial accounting concepts (SFAC). This grouping of conceptual standards should become the foundation of generally accepted accounting principles (GAAP).

These GAAP should be written in such a way that informed practitioners can reach similar conclusions about similar transactions. They should reflect economic events and not become so enmeshed in detail that concern for form overshadows substance. As a technical partner of a large national firm said recently when he was asked about a thorny problem, "This question is rule-specific-you have to meet the form of the rule, not the substance."

Unless the FASB redirects its focus to conceptual issues, continued environmental change and pressure from special-interest groups to address specific questions will cause it to spend even more time on implementation guidance, and the more important conceptual issues will not receive the attention they deserve. The result will be the erosion of the FASB's effectiveness and deterioration of accounting standards overall.

Further, by wrestling with implementation issues, the FASB may compromise its objectivity in dealing with conceptual issues.

Where can you get implementation guidance?

But if we separate implementation from concepts, who will develop implementation guidance?

Implementation issues are best delegated to other bodies. Implementation guidance for both specific transactions and industry related issues can be developed either by a group such as the present FASB staff or by another entity, such as the AICPA's Accounting Standards Executive Committee (AcSEC). The AICPA industry committees have enabled it and ACSEC to deal with many industry-specific issues in the past.

Implementation guidance that cuts across industry lines is perhaps best handled by the FASB staff or a similar group, supplemented by a group of fellows from industry and public accounting to make certain the guidance is practical-and necessary. Rotation of those participating in the fellows program helps to insure that their input reflects current practice and issues.

If implementation is separated from concepts, a new standard will not be required every time the economic or business climate changes or Wall Street develops a new transaction. Some implementation guidance should be issued at the same time the FASB issues a new standard. Other guidance will evolve as the use of the standard evolves. Further, the FASB should have the authority to request that guidance be issued when it perceives a need.

Implementation guidance must not override or alter the standards. Thus, each standard, and the rationale for and objective of the standard, must be clearly articulated.

Standards overload:

The approach we suggest also will reduce "standards overload" for the practitioner. All CPAs should be required to understand the conceptual standards, and they should understand implementation guidance for classes of transactions common to a broad range of entities and industries. While they do not need to have detailed knowledge of implementation guidance for specialized industries in which they do not practice, CPAs do need to know that information consistent with the conceptual standards is available.

The Committee believes it is more important for both the student and practitioner of accounting to understand the concepts of accounting for income taxes, for example, than to memorize the mechanics for calculating the liability. The most important thing we do as professionals is apply judgment.

Agenda topics requiring attention:

Several topics on the FASB's current agenda are conceptual. We encourage the FASB to pursue them-and to keep them at the conceptual level. These include discounting (or the use of the interest method), impairment of long-lived assets, financial instruments, fair-value accounting, and the reporting entity (consolidations). Differences between for-profit and not-for-profit accounting also require attention.

We feel discounting has first priority because it affects so many other troublesome areas, such as deferred taxes. We have reluctantly included financial instruments in this list because of our concern that the proposed disclosures will result in detailed listings of boilerplate statements similar to the S-1 disclosures in Securities and Exchange Commission registration statements, which are written by lawyers.

Getting there from here:

A few steps are necessary to implement the approach we have suggested:

* The conceptual framework should be completed and reexposed, with the understanding that the final SFAC would represent Level A GAAP. Some members of our Committee feel that practitioners did not focus on exposure drafts of the original SFAC because the exposure drafts were not intended as future standards but rather just as guidance for the FASB itself.

* Existing statements should be analyzed to separate standards from implementation guidance. The portion of existing statements that represent standards (e.g., much of Statement 5) would be included in the new standards, while the guidance portion (e.g., much of Statement 13) would be included with guidance publications.

* Existing GAAP should be grandfathered into the new structure to avoid disruption of practice. Areas in which existing GAAP depart from the new standards should be highlighted to avoid confusion. While practical exceptions to standards that are nevertheless conceptually sound are to be expected, these exceptions should be clearly identified as such (as they are, for example, in Statement 87) so that the concepts remain clear. These exceptions should be dealt with over a period of time, depending on their significance and their effect on public interest.

* The conceptual standards should be designated Level A GAAP and implementation guidance should become a lower level of GAAP under AICPA Rule 203. Nevertheless, auditors and those who prepare financial statements should have to justify any departure from the implementation guidance.

Ongoing process:

After these initial steps are completed, the following steps need to be taken:

* The FASB must continually evaluate any existing GAAP that differ from the new standards. The FASB should either approve retaining these exceptions to the standards or take steps to eliminate the exceptions over time. (The FASB should not forget that "generally accepted" are the first two words of GAAP!)

* The FASB should have some authority to set agenda items for the bodies that issue implementation guidance. Some Committee members feel that a majority vote of the FASB should be sufficient to override any guidance issued by these bodies. The danger here is that, if the FASB has such veto power, it may be tempted to write implementation once again. This tendency should be avoided.

* To help the practitioner, the FASB should codify existing GAAP in a logical sequence, with industry-specific and transactional guidance indexed under broad headings but clearly separate from the conceptual standards.

Other recommendations:

The Committee also developed other suggestions for improving the standard-setting process, as set forth in the paragraphs below.

* The FASB should do extensive field testing before it issues a standard. The field test would identify implementation problems before a standard is issued, thereby avoiding lengthy delays and reevaluation after the standard is issued.

Field testing of FASB proposals will also generate better understanding of the standard because all companies learn from the experiences of those that participated in the test, which in turn will facilitate implementation. This approach was quite successful, for example, with Statement 87, and it appears to have been beneficial in the other postemployment benefits project.

Further, the FASB should not rush to issue a pronouncement in response to pressure the Board feels to meet questionable deadlines.

* While the FASB is required to operate in "full sunshine," we feel that it would operate more effectively if it conducted some of its activities outside of public forums. Public scrutiny hampers free interchange. If the FASB is to continue to be effective, it must not be forced to operate in a way that was appropriate 15 years ago. Brainstorming is often a useful exercise, but it cannot be done in the public view. We recommend, therefore, that the sunshine rules be relaxed.

* The Emerging Issues Task Force serves an important need. We applaud its efforts and support its continuation. We believe that the transition to conceptual rules we have described will allow the EITF to develop quickly the guidance needed to address new developments on Wall Street. We are concerned, however, that EITF recommendations can be implemented immediately without due process. Some method of validating EITF guidance needs to be implemented.

* While the Committee does not support different measurement for small or private firms, we recommend the FASB consider disclosure relief for these organizations on a standard-by-standard basis, as it has in the past. We urge the FASB to examine more standards from this perspective in the future.

* The Small Business Advisory Group of the AICPA should play a more active role in the standard-setting process. Field testing should regularly include small businesses, and exposure drafts and final statements should clearly identify their impact on small business. Small-business interests should also be represented in the bodies that develop implementation guidance.

* We support involvement in international accounting standards. Globalization of financial markets is a reality, and globalization of accounting standards is the logical next step. The U.S. should play a leadership role in developing international standards, and the FASB should consider each new statement in the context of international standards, with the long-term objective of consistency.

* As a further step in recognizing the stability of standards, the majority of the Committee supports the five-of-seven majority vote required for passage of new standards.

* The AICPA should become a more active participant in the standard-setting process. The AICPA has adopted a hands-off policy to preserve the FASB's independence from the public accounting profession. But we feel that if the balanced input of users, preparers, and public accountants is to be maintained in the interest of better standards, the AICPA should be more proactive in articulating its views.

The wrap-up;

The Accounting Principles and Auditing Standards Committee of the California Society of CPAs believes that, while the standard-setting process of the FASB is basically working and serving the public interest, it needs to be improved. The problems with Statement 96, the changes in Statements 98 through 102, and the uproar over other postemployment benefits are indicative of the problems that must be resolved. We have offered several suggestions on how the process can be made more effective.

Our overriding recommendation is that the FASB move away from issuing detailed implementation guidance. The FASB's resources should be spent on developing and improving conceptual accounting standards; implementation of these standards should be delegated to other bodies, with the FASB's oversight.

By so doing, the FASB will focus the profession on conceptual standards, which should increase compliance through better understanding, remove some of the natural tendency to try to "beat" rules that appear to be arbitrary, reduce cries of standards overload, improve the quality of the standards, and free up the FASB to deal with difficult conceptual issues-its proper domain.

Stan Smith, a partner in BDO Seidman's Los Angeles office, served as chairman of the APAS Committee of the California Society of Certified Public Accountants for 1987-1989. Dr Mary Barth was Professional Response Coordinator for the Committee during the same period.

Technically speaking.

Pension funds-what does the future hold?

Members of FEI's Committee on the Investment Of Employee Benefit Assets (CIEBA) and the Committee's Advisory Council convened in Washington on October 10 and 11 for CIEBA's fourth annual meeting, which was open to all FEI members for the first time. Congressional leaders, investment managers, and plan sponsors discussed the problems and opportunities confronting the private pension system. Selections from the presentations follow.

A fragmented market:

Prior to 1965, the individual, trading individual stocks, was the primary decision-maker in the investment market, R. Sheldon Johnson, managing director of Morgan Stanley & Co., told his audience. Since then, assets have become concentrated in institutions and bloc trading has become primary. In the 1980s, performance became important to pension plans, and plan sponsors became the decision-makers, leading to trading by asset class.

Technology has allowed new trading systems to develop. Pointing out that there are 55 kinds of trading systems around the world-24 in North America, 26 in Europe, and five in the Pacific RimJohnson expressed concern over this market fragmentation.

The fragmentation has implications for liquidity. "What market should your order be in to get the best execution at any single point in time?" he asked. Regional markets are taking small order flows away from big market makers. Specialists are required to maintain orderly markets and it is the small orders that give the liquidity for big trades, johnson stated.

Trading cost is not only the cost per share, he pointed out. There is an opportunity cost. Then, what is the best market price? It is increasingly difficult to tie all these systems together to determine what system will provide the most efficient access to markets, or which trading environments meet your trading needs, which is the parallel objective to lowering costs.

Financial issues-the Treasury's perspective:

Fostering competitiveness while protecting financial safety and soundness is the goal of the U.S. Treasury Department, declared Under Secretary for Finance Robert Glauber. Glauber expressed the view that a Federal government guarantee can serve useful public purposes, although it weakens the forces of market discipline to restrain excessive risk taking.

Thus, if safety and soundness are to be maintained, other forces must take the place of market discipline, he stated. Reforms adopted and others proposed would provide alternatives to market discipline. Glauber described the following three alternatives and the Treasury's views on them.

* Increased investor capital. Adequate investor capital must be up front and at risk to absorb losses and to provide a strong incentive to monitor and control risk. The S&L "bail-out" legislation requires adequate capital levels or the institution will be merged or taken over by the Resolution Trust Corporation.

Improved regulatory supervision. This calls for "better, not more," regulation. Closer monitoring is necessary. Further, thrift regulators' charter and supervision function must be divorced from the insurance function. This is also true in the case of government-sponsored enterprises (GSE) such as "Fannie Mae" and "Freddie Mac." Legislation has been proposed to require these GSEs to maintain an AAA rating, exclusive of government guarantees.

In securities market reform, regulation must recognize that stocks, stock options, and stock index futures are essentially one market, and placing the key market regulatory functions in the hands of a single agency makes sense. The Treasury's proposal to consolidate responsibility and authority for margins on all three instruments at the Federal Reserve would be an important step in reducing the danger of a major market disruption. Unification of responsibility would not mean setting margins at the same level for all instruments, but would ensure that when setting margins for one instrument there is consideration of the others.

* Enhanced enforcement. Any human endeavor involves risk/reward calculations. Unless the penalty for illegal or inappropriate risk-taking involves a credible sanction, the propensity for self-enrichment will often win. Without tough financial and incarceration penalties, the incentives encouraging financial institution mismanagement are given full play. With these mechanisms in place to strengthen financial safety and soundness, it would be possible, and, Glauber emphasized, absolutely necessary, to give greater freedom to financial service institutions to provide the benefits of competition to consumers and to strengthen their own competitive position in the world arena.

Corporate governance an the proxy:

Does the proxy system serve as an effective mechanism for sharing director accountability for oversight of the management of public companies? Should a distinction be made between long-term and short-term holders? Is corporate democracy appropriate for corporate governance? Will all shareholders benefit under rules directed to large shareholders?

These are some of the significant policy issues involved in proposals for changes in the rules governing the proxy process that have been presented to the SEC, according to Catherine Dixon, deputy chief of the Office of Tender Offers in the SEC's Division of Corporate Finance. Dixon reviewed proposals made by the California Public Employees Retirement System (CALPERS), the United Shareholders Association, and some corporations. (See box.)

The SEC is engaged in a broad review of the effectiveness of the proxy rules because of these proposals and the "dramatic growth" of equity holdings among institutions, she explained. Dixon outlined the fundamental policy guidelines that will be followed in the review.

The first guideline is to maintain the right of fair corporate suffrage. A question to be considered, she said, is whether the anti-takeover policies of some states affect the competitiveness of U.S. companies by insulating the incumbents from tender offers or proxy contests, no matter how poor their stewardship.

A second guideline is whether there are unnecessary costs to both the proxy issuer and third-party solicitations that could be eliminated consistent with shareholder protection. In connection with this question, Dixon reported that the SEC has been asking corporations and institutional investors what their costs are in proxy solicitation. The SEC will attempt to determine the adequacy of protection against overuse of the solicitation process, and whether current rules interfere with the effective use of shareholder communications.

Dixon reviewed SEC Commissioner Philip Lochner's proposal to establish an independent commission composed of representatives from both institutions and business. The commission would study and propose standards that would help define what constitutes responsible board governance. These would include board size, the number of meetings, board composition and the independence of outside directors, board committees, essential functions, directors' commitment of time to those functions, directors' compensation, and limitations on the length of board service.

An upbeat forecast on employee benefits:

The current environment in Washington regarding employee benefits and pension plans should make the private sector and plan sponsors "feel quite good about prospects for the future," declared Dallas Salisbury, president of the Employee Benefit Research Institute.

Salisbury cited a number of changes from 1989 in the legislative process and in legislative policy discussions. A prime change is that Congressman Visclosky has decided that, rather than joint trusteeship, the issue for 1990 should be modification of pension funding standards in order to allow defined benefit pension plans (DBPP) to be more aggressively funded and to encourage small and large business to start plans. Salisbury told his audience that FEI and CIEBA can take considerable credit for that transformation.

Another positive change noted is at the Department of Labor, where there is a movement toward consideration of the implication of regulations for the sponsor community and an attempt to interact with the private sector to set rules that fulfill the law in the most workable fashion. Salisbury stated that there is a similar trend at the Treasury Department with the hiring of a 30-year veteran of the pension system and a movement to simplify and modify the rules.

In the Senate Finance Committee, he pointed out, a majority proposed to allow the use of excess pension assets for retiree medical financing, and proposed special treatment of reversions for those companies that choose to stay in the pension business. Further, he said, a majority now deems it desirable to talk about pension simplification and asset preservation.

While the changes may not be "what FEI would have dictated down to the details," Salisbury declared, there has been a fundamental change in the general philosophy and approach. The question is now asked, according to Salisbury, "Are we trying to cut back on the system, or are we trying to strengthen it?" He again credited CIEBA's hard work with changing the Congressional perspective.

Turning to the marketplace, Salisbury stated that one could almost view the problems in the insurance and banking industries as underscoring the tremendous importance of independent fiduciaries. The problems make clear the advantage of having highly trained professionals running pension funds within the corporation and the tremendous potential disadvantages and high cost of having pension fund management be a "merry-go-round" training ground of people who are there for only a short time because "after all, it really doesn't matter," he continued.

Asked where the bad news is, and what sponsors should be watching for, Salisbury warned against the acceleration of trends toward lump-sum distributions and the movement from defined benefit plans to defined contribution plans. If defined benefit plans-which provide benefit accruals and the prospect of retirement income for 90 to 95 percent of full-time workers in a given corporation-are replaced by defined contribution plans-which provide benefits for only 49 percent of full-time workers, have lump-sum distributions, and generous loan and hardship withdrawal provisions-plan sponsors should be concerned, he stated.

Salisbury told his audience to be positive and to engage in the overall debate on retirement policy if pension plans want to enhance their position with Congress and the press. "Find some things to be for," he declared, and "from time to time say something nice to Congress." He advised the CIEBA members to be so simplistic as to go to a dictionary and find out what a pension is. ("Pensions are not a lump-sum distribution," he said.)

CIEBA and FEI can make a difference by telling about the achievements of the employment-based pension system, he continued: "We should clearly understand that proposals for expanded tax preferences for family savings accounts or for IRAs are adverse to the long-term interests of a strong private pension system."

"If this organization is really interested in the long-term preservation of a pension system," Salisbury admonished, you must say that `We're going to try to lead. We're going to help define policy in this country. We're going to oppose those things that, even if good for some, are adverse to the pension system.'" He concluded with an order: "Lead."

What are the proposed changes in the proxy?

CALPERS proposals:

* Institute confidential voting and independent tabulation of shareholder ballots.

* Expand large shareholder access to issue of proxy materials to address non-election issues.

* Deregulate intershareholder communications to permit shareholders to discuss their position on issues subject to a proxy vote and on related issues among themselves without being concerned with SEC proxy rules.

* Mandate right for shareholders to access the current shareholder list-not only record holders, as now, but beneficial holders.

Eliminate the right of beneficial holders of securities held in street name to object to the disclosure of their identity to the issuer, and require direct registration of beneficial holders to facilitate corporate communications.

* Enhance disclosure obligations of public companies regarding issues of corporate governance, such as director independence.

United Shareholders Association proposals:

* Mandate access of large shareholders to issue proxy statements and require reimbursement of solicitation costs of these shareholders.

* Mandate shareholder vote on poison pills, green-mail, and golden parachutes.

Various corporate proposals:

* Exempt sophisticated investors from proxy rules with a one-year holding period to qualify for an exemption.

* Revise proxy rules regarding disclosure of management compensation to raise level for required reporting in light of inflation.

* Study relative costs and benefits of the entire proxy process.