The explosion of accounting standards.

Financial Executives Institute (FEI) announced, in an April 11, 1972 letter to the American Institute of Certified Public Accountants (AICPA) Board of Directors, that it agreed with the concept embodied in the Wheat Report on the establishment of the Financial Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB) and supporting organizations. The Report was prepared by an AICPA study group that was formed to review how accounting principles should be established. Chaired by the former Securities and Exchange Commission (SEC) Commissioner Francis Wheat, it became known as the "Wheat Committee."

At that time, standards had been formulated by the Accounting Standards Board (APB). "Procedures devised at the end of the 1950s for formulating financial accounting standards were probably appropriate at that time and have brought about notable improvements in financial reporting during the APB's 12-year history," read the opening of the Wheat Report. It went on to say that "the time has come for a change."

On the proposed new board, then-Chairman of FEI C. M. Allen noted in a May 4, 1972 speech the progress FEI had made in being recognized as the "spokesman for management in the financial community." He said, "It is entirely possible that the Wheat Committee might not have been appointed even, had it not been for the continued growth of FEI's influence in speaking out on accounting principles."

Charles C. Hornsbostel, FEI president, noted the importance of appointing men of extremely high caliber to the new standard-setting board and urged financial executives to study the complete Report. "The successful implementation of these recommendations will affect the future of financial reporting for many years to come," he said. "Every financial executive should be sure he is fully aware of all the ramifications of these proposed new organizations."

Also, as reported in FEI Bulletin, May 1972, he noted that industry would likely be called upon for financial support. "If we are to have a voice in the future of financial reporting, we must be willing to pay our way. When approached, your company should pledge at least your fair share of the funds that will be needed."

Commenting on the documents for establishing the new board, (FEI Bulletin, July 1972), FEI stated that the "implementation of the Wheat recommendations could mark 'the beginning of a significant and creative era in the formulation of improved accounting and financial reporting standards.'" FEI added that "it is essential that all those concerned in the process be dedicated to the purposes and the spirit of the Report ... There can be no success unless all participants are imbued with the determination that the recommendations of the Report be carried out fully ... [and] in a manner which will build public confidence in the endeavors of the new organizations."

Launched with this FEI support, the FASB has been doing its job since 1973, and is constantly changing as the business and financial environment around it changes. What follows are opinions from the chairs of the U.S. and international standard-setting bodies, and a former two-term FASB chair, who discuss what's top-of-mind in the 21st century.

--Ellen M. Heffes

* The FASB'S Accomplishments Since Its Founding

With the Financial Accounting Standards Board (FASB) now about one-third of a century old, it has outlasted any predecessor accounting standard-setting body. In trying to judge its accomplishments, first consider the expectations for FASB when it was started and the major concerns about the new system. Speeches by Leonard Savoie, then executive director of the AICPA, and a presentation by Reginald Jones, then chairman of the board of General Electric Co., hold keys to the early issues.

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Savoie and Jones each expressed cautious optimism about the new board and its structure. Savoie observed that the structure involved "responsibility without authority." He questioned whether FASB could actually be independent of the Securities and Exchange Commission (SEC) or whether it would become explicitly subservient to the commission, and he worried whether other interested parties would truly be supportive. In 1973, he said: "By their actions and attitudes, businessmen and professional accountants seem to be saying, 'We want accounting rules to be set in the private sector, only if we agree with the rules.'"

Jones had similar concerns as to whether the business community would support FASB, but argued that it would be in its best interests to do so. "We must recognize that with its first decision the new board is going to gore somebody's ox--and that will be the time for us to pull together--not to splinter apart," he said.

Given those early concerns, perhaps the board's major accomplishment is that it has survived thus far. In reality, however, FASB has a long list of accomplishments. Among them, according to this author, and not necessarily in order of importance, are:

* It has been able to achieve reasonable independence and has not become subservient to the SEC, the business community or the accounting profession.

* It has dealt with most of the major accounting issues that were identified as such when it began, and has not shied from controversy.

* It has established an exhaustive set of due-process operating procedures that continue to evolve as needs arise.

* It communicates well, so that all interested parties are informed and are encouraged to participate.

* It has made great strides in internationalizing financial reporting.

What follows is some detail about each point.

Independence: Savoie's concern about responsibility without authority may well be seen as a fundamental weakness of the current system. But it's also a strength, since the board can succeed only if others allow it to, and that forbearance depends on perceived satisfactory performance. Thus, the board's activities are constantly being "market tested," rather than it having a mandate that it must succeed.

In a sense, the board must create its own independence, and the crucial point is striking the right balance. If the SEC lost confidence in it, vital support would evaporate; if the board is seen as merely doing the bidding of the SEC or even the accounting firms, then other important support would be lost--notably that of the business community.

While FASB has no direct legal or other authority, actions taken early in its life by the AICPA and SEC provided considerable support. Just as FASB was beginning operations in 1973, the AICPA adopted Rule 203 of its Rules of Conduct, which requires auditors expressing opinions on financial statements in conformity with generally accepted accounting principles (GAAP) to ensure that those statements comply with all applicable FASB pronouncements.

That December, the SEC issued Accounting Series Release 150, which said the SEC would look to the FASB to take the leadership role in establishing and improving accounting principles, and that FASB pronouncements would be considered by the SEC to have "substantial authoritative support." (In 2003, the SEC officially recognized the FASB's standards as "generally accepted" for purposes of federal securities laws.)

Striking the right balance has often been described as getting everybody mad at you in approximately equal proportions. For FASB, that is inevitable to a large degree because of the diverse interests of its constituencies (companies, auditors, users, regulators). With the SEC the key player, it is remarkable that there have been just a few instances where the commission allowed itself to be so influenced by the political process that it applied pressure on the board.

Major Accounting Issues: As a result of its independence, the board has been able to take on and find reasonable solutions to most of the major accounting controversies from the early 1970s, as well as those that have arisen since then. These include projects on the original FASB agenda such as segment reporting, contingent losses, research and development, leases and foreign currency translation. Later topics included pensions, financial instruments, stock compensation, other postemployment benefits, income taxes and derivatives. More recently, the board has decided to reconsider pension and lease accounting.

To the best of my knowledge, the board has never avoided an issue because it was too controversial or too much of a "political hot potato." Some observers have said that the board used poor judgment in deciding to address certain topics (notably oil and gas accounting and stock compensation) where it seemed obvious that political considerations would be intense. While there may have been a certain amount of political naivete involved in those and a few other projects, it's doubtful that many can argue that the board has shirked its responsibilities. Some believe that certain answers did not go far enough, were too much of a compromise or otherwise represented a non-courageous outcome. While courageous leadership is necessary, you cannot get too far in front of your followership.

Strong Operating Procedures: The openness of the process contributes greatly to both credibility and communications. While open board meetings have sometimes created more heat than light, the board has never hidden anything, and operates on a "what-you-see-is-what-you-get" basis. Due process takes time. Some executives and public accountants seem to have suggested more process as a way of delaying or preventing certain rule changes--a point that cannot be proven with hard evidence.

More likely, the reason it takes so long to complete many projects is not the extensive due process, but rather, the inability of board members to reach agreement. While that can be frustrating to both FASB insiders and constituents, it is, perhaps, the consequence of dealing with controversial issues where there are usually no clear-cut solutions.

Communications: FASB's very open process is helpful to those who are interested in staying informed. Strong communications are necessary to reach the many parties who may be affected by new accounting standards but are not directly connected to the regular process. This is a never-ending battle. Every CFO or corporate controller who is new to his or her position needs to become informed about the board's process and projects. The same is true for new independent auditors, financial analysts, SEC Commissioners, Members of Congress and so on.

Reasonable efforts have been made to get the word out early and often, and over the years the board has developed numerous communications tools--including newsletters, alerts, speeches and a valuable, timely website.

Internationalization: Almost all of the accomplishments mentioned have occurred throughout the board's existence, but one of the most important activities is a comparative newcomer: the effort to play a leading role in internationalizing accounting. In the past, other countries often looked to the FASB to take a leadership role by dealing first with contentious issues. While many countries continue to follow the board's lead, it is now more common for the board to learn from the experience of others.

In particular, most of the board's major projects are now being conducted jointly with the International Accounting Standards Board (IASB). The board says that international convergence of accounting standards is one of its primary goals, although it also makes clear that this means agreement on standards of high quality and not a "lowest common-denominator" approach.

Areas for Improvement

The accomplishments discussed add up to an impressive track record to date, and I express pride that at least some of them occurred during my tenure as chairman. However, opportunities to improve continue, and improvement is essential for the board's continued success. Three areas for improvement are: building trust, strategic planning and simplicity.

* Building Trust. Greater trust must be built between FASB and all of its constituents, particularly the corporate community and accounting firms.

* Strategic Planning. In 1992, the board developed the first notion of a strategic plan when it decided to address many of its constituents' concerns through a new program called "The Three S's" (selectivity--dealing with the highest-potential issues first; simplicity--making accounting standards simpler and shorter; and speed--dealing with issues more quickly).

While board members all agreed on the goals, they unfortunately did not change their day-to-day behavior much. FASB has often criticized the resistance to change of many of its constituents, but the board itself has also been slow to embrace the changes inherent in the strategic plan. Many other organizations have had similar problems in operationalizing their strategic plans, and FASB should give this the very high priority that it deserves.

* Simplicity. This involves the complexity of accounting standards. While one goal of FASB's initial strategic planning efforts was to shoot for simplicity in accounting standards, in the years since board members first agreed on that goal, the standards have gotten much more complicated. FASB often argues that complexity is necessary because auditors, regulators and corporations ask for it; they want clear answers for nearly all possible situations they might encounter.

But rather than acceding to the requests, the board should ask itself: "Will all the detail actually result in better financial reporting, or will this galloping complexity outpace the ability of many professional accountants to keep up with and understand and, thus, cause a real decline in application quality of standards?" Reasonable accounting standards and excellent professional judgment are both essential ingredients in an effective financial reporting framework, and the trick is finding the right balance; FASB's scales need to be lightened up a little on the complexity side.

Over the past 33 years, FASB has accomplished a great deal--perhaps more than might have been reasonably expected. It is an excellent system already, clearly the best in the world, and there appears to be a commitment to get better.

By Dennis R. Beresford

* Modern Financial Reporting Framework: Convergence

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While today's FEI members face a world that is much different from that of their predecessors in 1931, one similarity between then and now is clear: the focus on financial reporting and the implementation of new financial reporting rules has been intense. In the wake of the 1929 stock market crash, the U.S. ushered in new securities laws and created a strong and independent enforcement mechanism in the U.S. SEC. These steps helped to ensure the strength of U.S. capital markets and served as a model for the rest of the world.

Now in the 21st century, the rules governing financial reporting are adapting to new economic challenges, largely as a result of the globalization of the world's economies and increasing complexity of market transactions. The task of today's financial accounting standard-setters is to develop a system that accounts in an understandable manner for the evolution of financial markets.

Capital markets have always required accounting standards that are consistent, comprehensive and based on clear principles to enable financial reports to reflect underlying economic reality. In today's markets, that reality is constantly changing, and financial reporting rules must evolve with it. The growing acceptance of international accounting standards (International Financial Reporting Standards, or IFRS) reflects trends in an increasingly integrating global economy.

Since the IASB was established in 2001, the effort to institute IFRS as the international basis of accounting has gained momentum. Many countries agreed to adopt IFRS for publicly traded companies by either Jan. 1, 2005 or Jan. 1, 2007. A Deloitte & Touche study indicates that more than 100 countries now require, permit or have a policy of convergence with IFRS.

For example, more than 8,000 publicly traded companies in the European Union (EU) have recently released their first full-year results under a new IFRS requirement. Australia, Hong Kong and South Africa have followed Europe's lead. Many Latin American, African and Asian countries, including China, India and Japan, have formal policies of convergence with international standards.

Significantly, progress has also been made towards the convergence of U.S. GAAP and IFRS, improving the prospects that a common financial reporting language will serve the world's major capital markets in the near future. The real catalyst for convergence work between the U.S. FASB and IASB was the issuance of a memorandum of understanding, known as the "Norwalk Agreement," following the boards' joint meeting in September 2002.

The agreement marked the first time a strategy was established to eliminate differences between U.S. GAAP and IFRS. The boards agreed to identify differences pinpointed by examining the reconciliation statements filed by non-U.S. companies using IFRS and registered in the U.S. In tackling these differences, the boards decided to focus on making the principle of the standards similar with an understanding that differences in the detailed application may require additional time to address. And they recognized the need to limit future divergences of U.S. GAAP and IFRS, once existing differences were eliminated and new standards were developed. Also, FASB and IASB agreed to coordinate their work programs.

While progress on the basis of the Norwalk Agreement has been steady--with both boards making changes in their existing standards--both FASB and IASB are conscious of changes in the environments in which they operate. For a long time, the U.S. SEC requirement for the reconciliation of non-U.S. accounts to U.S. GAAP has served as an irritant and impediment to those seeking access to U.S. capital markets. With the improvements to IFRS, progress on convergence and the growing use of IFRS, SEC staff published a "roadmap" describing a process by which it would consider the removal of the reconciliation requirement for non-U.S. companies using IFRS, by no later than 2009. This decision would require, among other things, a robust convergence process to be in place and to continue following the removal of the reconciliation requirement.

From the standard-setting viewpoint, the SEC staff roadmap provided an opportunity. IASB and FASB would no longer need to concentrate on a possibly endless series of changes to get the reconciliation removed. IASB and FASB agreed that trying to eliminate existing differences between two standards that are in need of significant improvement is not the best use of the boards' resources--instead, a new common standard should be developed that improves the financial information reported to investors. This would also have the benefit of reducing the amount of change required to achieve convergence of IFRS and U.S. GAAP.

In February, FASB and IASB issued a new memorandum of understanding meeting the objectives of the SEC staff roadmap and providing a clear statement of priorities and convergence timetables. The memorandum states that convergence work would run on two tracks. The goal by 2008 is to reach a conclusion about whether existing major differences of principle in a few focused areas should be eliminated through one or more short-term standard-setting projects and, if so, complete or substantially complete work in those areas.

For IASB, this would mean decisions regarding the necessity for change in four targeted areas: borrowing costs, joint ventures, government grants and segment reporting. FASB would also need to examine and decide whether to adopt IASB's policies on the fair value option, investment properties, research and development expenditures and subsequent events. In addition, FASB and IASB will consider converging their standards on income taxes and impairment.

Second, and more substantially, the goal by 2008 is to have made significant progress in a number of areas identified by both boards where current accounting practices of U.S. GAAP and IFRS are considered outdated and candidates for improvement. These longer-term projects tackle some of the more difficult conceptual issues facing standard-setters today, including off-balance sheet items (such as pensions and leases), financial instruments, questions of measurement and consolidations. All of these proposed topics have been either on both boards' agendas for some time or on their active research agendas. Thus, this is a program involving minimal change to the existing agenda that will provide the two boards with time to analyze, consult and decide upon high-quality solutions to these questions.

Towards a Principled Approach

While there is a clear commitment among a wide range of interested parties to pursue convergence, many have asked the two boards to reduce complexity in financial reporting. Of course, some of the complexity in accounting standards reflects the complexity of modern market transactions. However, standards should not add to complexity where a simpler approach and clarity would better serve investors.

IASB does not want convergence to lead to a rulebook approach to international standards, and is committed to writing principles-based standards. IASB believes that principles-based standards are easier to apply and actually cause more rigorous and consistent application of the standards' intent. This does not mean standards will be more lax, and the contrary could be the case. A well-defined principle will allow for few exceptions and bright lines, which have been used to obfuscate financial results for too long.

Of course, the ability to sustain a principles-based system depends as much on companies, regulators and auditors as it does the standard-setters. If abuses of the principles arise, standard-setters will be forced to take preventive action. If lawyers and regulators continually second-guess honest judgments made by preparers and auditors, the demand for rules will arise, and IASB will find it difficult to resist. In the end, standard-setters will provide the financial reporting community with the standards that they deserve.

Acceptance of such a principles-based approach will be difficult for some, particularly for many in the U.S., where auditors and companies have sought protection and guidance in the form of rules. A reliance on principles will demand greater judgment be exercised and a shift in culture for those involved with financial reporting.

Financial executives have an important role in fostering a principles-based effort. If such a change could occur, the world will be closer to a common set of financial reporting standards by the end of the decade. The potential benefits are great--the successful integration of the world's capital markets, a reduction in complexity and compliance costs and increased transparency for investors.

By Sir David Tweedie 

* Reducing Complexity And Maintaining High-Quality Financial Reporting

In the more than 70 years that have elapsed since passage of the Securities Act of 1933, accounting, auditing and reporting guidance has grown to encompass thousands of pronouncements that make up U.S. generally accepted accounting and auditing standards and U.S. SEC rules, regulations and interpretations governing financial reporting.

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These range from major standards on broad topics such as accounting for business combinations, to guidance on accounting practices for specific industries, to narrow interpretations and rulings on transactions. While basic principles are to be found in many of the standards, these have often been overwhelmed by detailed rules, bright lines and exceptions, both in the standards themselves and in subsequent interpretations, rules and regulations.

While quite laudably intended to ease implementation and promote greater consistency in reporting, they inevitably add to the overall complexity of the system and can reduce the transparency of the resulting financial information. This complex system reflects, in part, the complexity inherent in reporting on increasingly diverse and complicated business transactions and arrangements. But the complexity has also been building for many years as a result of various structural, institutional, cultural and behavioral forces in the system.

Long touted by some as a strength of the U.S. reporting system, the detail and volume of accounting, auditing and reporting guidance now pose a major challenge to maintaining and enhancing the quality and transparency of financial reporting to investors and the capital markets. Many believe that the current system has engendered a check-the-box, form-over-substance approach to accounting, auditing and reporting by preparers, auditors and regulators, sapping professionalism and increasingly necessitating the involvement of technical experts to ensure compliance. It also has provided fertile ground for those attempting to structure form-over-substance arrangements to obtain desired accounting outcomes.

This complexity has added to the costs and effort involved in financial reporting, which often fall disproportionately on small and private companies and their auditors. It has created a black-box view of financial reporting by many who are not familiar with the intricacies of the underlying accounting, auditing and reporting requirements. For professional investors and analysts, it results in a lack of transparency and significant analytical complexity in using reported financial information. It is also viewed as a contributory factor to the unacceptably high and increasing number of restatements of financial reports by public companies.

So, we have both a complexity problem and a transparency issue.

Not surprisingly, there are varying perspectives on what constitutes "complexity;" there are also different views on what reducing complexity means. To many preparers, reducing complexity seems to imply accounting and reporting that is easier to do. For auditors, it would seem to imply accounting and reporting that is easier to audit. For users, it seems to mean making reported financial information more understandable and useful, including making it more relevant and representationally faithful of the underlying economics--objectives that may not translate into accounting and reporting that is easier to do or to audit.

The Forces of Complexity in the System

How did we get to this point of having such a complex reporting system?

First and foremost, business has gotten more complex. But, in my view, there are also a number of powerful forces that have and continue to generate complexity. Among these forces are the conflicting perspectives and agendas of the participants in the reporting process; resistance to change; outdated rules-based legacy accounting standards that fail to report the economic effects of transactions and events; an evolutionary approach to standard-setting that can result in non-conceptually based compromises, exceptions and inconsistencies in standards over time; a continuing focus and emphasis on short-term earnings; gaps in the education and training of accountants; anti-abuse rules aimed at curbing the continuing use of accounting-motivated transactions to burnish reported financial results; attempts to politicize standard-setting and regulation; and a palpable fear of the potential consequences of being second-guessed by regulators, enforcers and the trial bar.

In our culture, many of these forces create a constant demand for detailed rules, exceptions, bright lines and safe harbors to deter preparers, auditors, audit committees and boards from exercising professional judgment. The result is disclosures that, while lengthy and dense, all too often are boilerplate, overly legalistic and fail to effectively communicate important information.

For our part, the FASB, with the encouragement of the SEC, has undertaken a three-pronged effort aimed at trying to do what we can to respond to these issues. First, we have been and plan to continue to systematically readdress accounting standards in major areas for which the existing complex and outdated rules fail to provide relevant and transparent financial information. Next, the board has three broad initiatives aimed at improving the understandability, consistency and overall usability of the existing accounting literature.

These include:

1) Undertaking a massive project to develop a comprehensive and integrated codification of all existing accounting literature, organized by subject matter, that would become an easily retrievable single source for all of GAAP, and that should provide a useful roadmap to identifying those areas most in need of simplification;

2) Attempting to stem the proliferation of new pronouncements emanating from multiple sources by consolidating U.S. accounting standard setting under its auspices; and

3) Developing new standards more consistent with a "principles-based" or "objectives-oriented" system. FASB has undertaken a major project to strengthen its existing conceptual framework in order to provide a more solid and consistent foundation for the development of principles-based standards in the future.

While these activities, aimed at reducing complexity and improving accounting standards, are integral to reversing the trend that has been building for a number of years, on their own, they are unlikely to prove successful in significantly reducing the complexity of our reporting system.

So, I believe that the time has come for collective action to address these issues. Such an effort could result in significant changes to the reporting system, including institutional and structural changes--some of which could impact the FASB. From where I sit, I believe the status quo is neither acceptable nor sustainable. Our reporting system, while probably the best in the world, is too complex and is capable of providing more transparent, understandable and useful information to investors and the capital markets.

From the creation of the SEC over 70 years ago through the Sarbanes-Oxley Act of 2002, the need for sound, transparent and credible information for investors and the capital markets has been recognized as a national priority on which the success of our capital markets in contributing to our economic well-being rests.

Solving this problem will require the attention, support and concerted and coordinated action of market participants and policy-makers. With cooperation from all parties of the system--preparers, auditors and users, as well as the SEC and the Public Company Accounting Oversight Board (PCAOB), we can bring about the broad-based changes needed to significantly reduce complexity and improve the overall usefulness of reported financial information.

Such an effort will not be easy and will take time, but we believe it is one of national importance and one that deserves the support of us all.

As history likely repeats itself, the next time FEI celebrates a landmark anniversary, there'll continue to be economic challenges. But if the changes presented here by the leaders of the accounting standard-setting organizations are activated, it's also likely that future financial reporting could well reflect the truly global market economies.

By Robert H. Herz

By Dennis R. Beresford, Robert H. Herz and Sir David Tweedie

RELATED ARTICLE: FASB 1973 Agenda

As reported in Financial Executive, June 1973: FASB set task forces to conduct research on seven subjects in its initial agenda:

1. Accounting for foreign currency translation;

2. Reporting by diversified companies;

3. Criteria for determining materiality;

4. Accounting for leases by lessees and lessors;

5. Accruing reserves for future losses associated with catastrophe reserves, foreign considerations and self-insurance;

6. Accounting for certain costs such as research and development, start-up and relocation; and

7. Qualitative standards for financial reporting.