Good morning, Chairman Sarbanes, Senator Gramm, and other members of the Senate Banking Committee. I am Denny Beresford, a professor of accounting at The University of Georgia, and I am honored to have been invited to appear before you today.
First, let me briefly describe my background. Before joining the faculty at The University of Georgia in July 1997, I served for ten and a half years as Chairman of the Financial Accounting Standards Board. Before my FASB appointment, I was a partner with the accounting firm now known as Ernst & Young. I spent ten years in the Los Angeles office of E&Y and then sixteen years in the firmís national office in Cleveland. For the last ten years of my time with E&Y I was partner in charge of accounting standards. I am now a retired partner of E&Y and I collect a fixed, monthly retirement amount from the firm.
In addition to my full-time teaching duties, I am involved in professional committees that follow and comment on new financial reporting developments. I also continue to speak and write on financial reporting matters. Additionally, I have served as a consultant to audit committees of public companies and I have provided expert witness services to several corporations and accounting firms. Finally, I am a director of National Service Industries, Inc., a New York Stock Exchange listed company, and I am chairman of NSIís audit committee.
One other fact that probably should be noted for the record is that I was a shareholder of Enron Corp. (Enron) for a very brief period last fall. I purchased 2,000 shares on November 5 and sold them on November 14, incurring a loss of $7,241. I blame no one but myself for this poor investment decision.
The comments that follow are my personal views. They should not be attributed to Ernst & Young, The University of Georgia, or any other organization or individual with whom I may have some association.
What You Have Asked Me to Do
The letter inviting me to appear today asked for my comments on "financial reporting by public companies, accounting standards, and oversight of the accounting profession" in light of recent high-profile business failures including Enron. The letter also invited my recommendations about ways to deal with the issues I discuss.
In considering my response to those requests, please keep in mind that I am no longer an "insider." There are, no doubt, certain changes that have taken place in the accounting and auditing world of which I am not fully informed at present. But with over 40 years of total experience and about 25 years working at reasonably high levels in the accounting profession, I hope my comments will be of some value to you.
My comments will relate primarily to financial reporting matters because that is the area where I spent most of my professional career. To put things in perspective, this statement begins with some comments about the current state of financial reporting. It then moves to several areas in which I have both comments and recommendations for improvement. The last section summarizes the most important of my recommendations.
Recently, there has been a great deal of criticism of accounting and auditing practices in the U.S. relating to Enron and several other high profile cases. It is quite appropriate that your Committee and other groups in Washington try to determine the root cause of the Enron matter and penalize any deserving individuals or organizations after determining the facts. It is also quite appropriate that your Committee and other groups in Washington consider whether there are changes that can be made to accounting or auditing rules and regulations to lower the chance that similar problems will occur in the future. However, I believe it is critical that these latter efforts keep in mind that our current system of financial reporting produces excellent information in the vast majority of situations. Care must be taken to see that criticism is constructive Ė that it leads to improvements in the current system and not to damaging it.
I donít think that any of us fully understand all that happened in the Enron matter. Even with the restated financial information now available, the Powers report, and the volumes of newspaper and magazine articles analyzing the situation, there remain many unanswered questions regarding Enronís business practices and the way it accounted for them. However, it does appear to me that the basic accounting problem boils down to the fact that Enron failed to comply with generally accepted accounting principles (GAAP). Enron first admitted this when it eliminated the $1 billion plus notes receivable related to its stock issued to special purpose entities (SPEís). Enron admitted additional accounting errors when it subsequently restated its financial statements to consolidate certain SPEís that it determined did not qualify for "off balance sheet" treatment under GAAP. As I will cover later, the accounting principles for SPEís certainly warrant further consideration. But the rules we have now would have produced more appropriate information if only Enron had followed them.
As a former standards setter, I am aware of the dangers of the law of unintended consequences faced by all rule makers. As you are well aware, often in trying to resolve one issue, a rule can create other problems that were never intended. The less thorough and considered the process leading to the new rule, the more likely this will occur.
Some have argued that the Enron problems were "caused" by the legislative reforms designed to reduce frivolous lawsuits. Others believe the "cause" was the failure to legislate reforms to limit the scope of work performed by public accountants. Still others see the root of the problems as easy money, an investment system fraught with moral hazard, and/or a decline in societal ethics or moral standards, for which there is no lack of opinion as to where to place the blame.
Each of these opinions certainly has emotional resonance and there may be some element of truth in each of them. However, what seems more likely, based on what we know today, is that the collapse of Enron had more to do with human errors, some perhaps innocent, some perhaps not, that remained undetected because of a massive breakdown in the systems and controls that either were, or should have been, designed to discover them.
These are very real problems for Enron. They should be investigated and any wrongdoing appropriately penalized. In the process, any systemic problems that are discovered should be appropriately addressed. However, as of today, there is no evidence that the Enron problems extend to a majority of corporate executives, board members, outside accountants, or outside lawyers. Therefore, I would caution against immediate widespread reform that could well invoke the law of unintended consequences.
I am not suggesting that this will be an easy task. I am well aware that Congress has an enormously difficult balancing act. It must get to the bottom of the Enron situation and ensure that appropriate actions are taken. At the same time, it must do so in a manner that does not unnecessarily create a chilling pall over a mostly well-designed economic model and the vast majority of those who play by its rules. To this end, generally it has been proven more effective and less disruptive if, when possible, deliberative, private sector action, rather than a legislative solution, is the chosen reform vehicle.
The body that is responsible for establishing most of GAAP at present is, of course, the FASB. Much of what I will say in the remainder of this statement will focus on the work of the Board. That Board has served with distinction for nearly 30 years and I am confident that hearings like this will lead to suggestions to further improve the FASBís processes. In January 1990, I wrote an article for the Journal of Accountancy that included the following summary of the FASB:
"The FASB is unique. It is a private-sector institution performing a public function that is defined in a federal statute. This means it carries the weight of public expectations as expressed both in the Securities Exchange Act of 1934 and in repeated congressional investigations and hearings over the years. With government looking over its shoulder, the board must serve a private-sector constituency made up of several important segments whose interests often are at variance with one another. Thus, the boardís relationship with its constituents is a continuing test of a sophisticated and subtle democratic process. The process doesnít work unless divergent private viewpoints are heard and can be reconciled. The boardís responsibility is to try to do just that Ė in a manner that will best serve the public interest."
Understanding Financial Reports Requires Education and Diligence
To further put into context my following remarks, I would like to cite one of my favorite quotes from the accounting literature. FASB Concepts Statement No. 1, "Objectives of Financial Reporting by Business Enterprises," states the following:
"Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence (paragraph 34, emphasis added)."
It is important to keep in mind these comments about "reasonable understanding" and "reasonable diligence" as you and others evaluate the current financial reporting system and consider the need for further improvements. Most businesses are complicated and attempts to portray their economic activities in a few financial statements and accompanying footnotes necessarily involves numerous tradeoffs. Because of this, relatively few investors are experts at reading corporate financial reports.
Let me illustrate this point with a personal experience. I presently teach both graduate accounting students and MBA candidates. Most of the MBA students have had relatively little exposure to financial accounting and at the University of Georgia we expect them to be able to absorb the basics in 37.5 classroom hours of instruction. While my students are intelligent and highly motivated individuals, only rudimentary principles of accounting can be absorbed in this amount of time. So our MBA graduates who become business executives, investment bankers, etc., are not expert accountants by any stretch of the imagination.
And these women and men are among the most sophisticated individuals in our society with respect to business and accounting matters. Most Americans do not have graduate degrees in business or any specific education in accounting matters. It is clearly unreasonable, in my view, to expect most Americans to understand all of the nuances of financial reports.
I note this primarily to dispel the notion that financial reports must somehow become fully understandable to any individual who invests in stocks or bonds of public companies. It just isnít going to happen. While we should strive to make those reports more accessible to all, I think a more realistic objective is to work on improving information so that financial analysts, lending officers, and other relatively sophisticated intermediaries can use that information to provide better advice to individual investors and other appropriate parties.
Please donít misunderstand. It may sound as though Iím saying that accounting is some sort of secret language that only CPAs with years of experience can speak, but that isnít what I mean to communicate. As I indicated earlier, my MBA students can assimilate a good, general understanding of basic financial statements and accounting principles in one semester. As a further illustration, over the past year and a half Iíve written a series of articles on corporate reporting for our local newspaper and many readers have told me that the articles help them gain a basic understanding of financial statements.
However, being able to generally grasp the financial reports of oneís small business or church, for example, doesnít necessarily lead to being able to decipher Enronís incredibly complicated financial statements. Enron was a complex business with energy and telecommunications operations, extensive trading activities, and sophisticated financing vehicles. Being able to reduce all of that to something like a Readerís Digest article that nearly all adults could understand is not a realistic expectation.
Congress Should Not Get Involved in Technical Accounting Issues
I was pleased to see one of the comments in former SEC Chairman Arthur Levittís op ed piece in the New York Times on January 17. In referring to the FASB, he said:
"This important agency must also be free from Congressional pressure, which is often applied when powerful corporations seek to undermine new accounting rules that might hurt their earnings."
I strongly agree that Congress must guard against becoming a hindrance to the accounting standard setting process. However, as with all perceived conflicts of interest, lines delineating "doing the right thing" from "helping a client or constituent" often can become blurred. A case from my personal experience where Congress allowed itself to become too involved in the technicalities of the reporting process was the debate over accounting for employee stock options in the early and mid 1990ís. As many of you may recall, the FASB had proposed that companies account for the expense represented by the fair value of stock options granted to officers and employees. The business community and accounting firms strongly opposed this proposal and a number of corporations engaged in a lobbying effort to stymie the FASBís initiative.
Certain members of Congress were sufficiently influenced by the appeals from corporate executives that they were persuaded to introduce legislation to counter the FASBís proposal. The legislation would have prohibited public companies from following any final FASB rule on this matter. More importantly, the legislation would have imposed requirements that the SEC repeat the FASBís process on any new accounting proposals, thus effectively eviscerating the FASB. Faced with the strong possibility that its purpose would have been eliminated by this legislation, the FASB made a strategic decision to require companies to disclose the effect of stock options in a footnote to the financial statements but not record the expense in the income statement.
Unfortunately, this was not the only example of Congressional interference in the FASBís technical decision making. In the 1970ís, Congress overrode the Board with respect to the accounting for oil and gas exploration costs. More recently, legislation very similar to that proposed in connection with the stock options matter was introduced in connection with accounting for derivative financial instruments. For the even more recent project on accounting for business combinations and goodwill, Congressional hearings were precipitated by corporate complaints of alleged unfavorable economic consequences of the FASBís proposals. And legislation was proposed that would have delayed implementation of that new accounting rule.
I have noted that two members of this committee are considering whether the federal government should take over responsibility for setting accounting standards. In support, a recent Wall Street Journal article refers to critics of the FASB, who claim in part that the FASB has been "too quick to cave in on critical issues." One of the examples given was the decision to scrap the proposal on accounting for stock compensation. I find this ironic. I am confident that the FASB could have and would have stood up to companies that disagreed with its conclusions on stock compensation. It "caved" only under congressional pressure that would have effectively legislated it out of business. Contrary to being an argument for government accounting standards setting, this is one of the very good reasons for the government to stay out of the technical accounting standards setting business.
As President Bush said in his recent State of the Union address, "Through stricter accounting standards and tougher disclosure requirements, corporate America must be made more accountable to employees and shareholders and held to the highest standards of conduct." The FASB has the mandate and the will to adopt stricter accounting standards and tougher disclosure requirements. However, it cannot achieve those goals when Congress urges lesser requirements. Congress must guard against emotional appeals from constituents that accounting rules will "ruin their businesses" or "destroy the economy." Reporting the substance of actual business decisions and activities is unlikely ever to have that result.
Congress, of course, has both the right and responsibility to provide strong oversight in this area. The FASB holds a public trust and Congress is entitled to examine how the Board is carrying out that duty, particularly in trying times like those at present. However, my view is that Congressí primary role in this area should be to see that the FASB is fulfilling its public obligations appropriately. Congress ought not to interfere with individual technical decisions.
Let me offer an example, of a situation about which I am very familiar, of how government oversight activities have been successful in influencing positive change in the private sector. The FASB currently is subject to oversight by the Financial Accounting Foundation (FAF). In turn, the SEC actively oversees the FAF, and Congress oversees the SEC and determines that the Commission carries out its responsibilities with respect to both the FAF and the FASB.
The Trustees of the FAF are responsible, by charter, for three major things. First, they appoint the members of the FASB (as well as its sister organization, the Governmental Accounting Standards Board). Second, they raise the funds necessary to finance the FASBís activities. Third, they oversee the FASB to make sure that the Board is carrying out its responsibilities in an unbiased and appropriate manner. By charter, the Trustees are not allowed to interfere with or otherwise influence the FASBís technical decisions on accounting standards matters.
During Arthur Levittís tenure at the SEC, he (and others) perceived that the Trustees of the FAF were not always sufficiently supportive of the FASB. He felt that there were instances where the Trustees acted in a way that might have been seen as endorsing the business communityís views on specific technical issues rather than supporting the FASBís independence and due process. He, therefore, proposed changes in the composition of the FAF Board of Trustees. He suggested that several more "public" members be added in place of some with close ties to the accounting profession and business community.
After months of debate, the FAF agreed to reorganize and several public members were added, including the current Chairman, Manuel Johnson (former Federal Reserve Vice Chairman), and David Ruder (former SEC Chairman). In my view, this was a significant improvement. It is now more evident that the FAF Trustees are acting to support the FASB and to make sure it is doing its job properly rather than the earlier perception that it was somehow trying to influence the Boardís decisions.
This is a very good example of how government oversight led to actions that resulted in positive changes in the private sector. It is particularly noteworthy that these changes were accomplished in a manner that supported, rather than undermined, private sector accounting standards setting activity.
The SECís Role is Vital
A fair amount of the rhetoric surrounding the Enron situation has focused on the SEC and particularly Chairman Harvey Pitt. Some journalists and other commentators have pointed to Chairman Pittís background as counsel to the AICPA, Andersen, and other accounting firms and have raised questions about whether he will vigorously pursue whatever remedies are called for with respect to Enron and Andersen as well as appropriate system wide changes. Some of those individuals also have pointed to Chairman Pittís remarks to the AICPA Council meeting a few months ago as an indication that there will be a "kinder and gentler" SEC with respect to dealing with accounting matters.
I have a different perspective. I do not know Chairman Pitt well, although I did meet him a number of years ago in his previous employment at the Commission. But I have worked closely with SEC Commissioners, accounting staff, and many other SEC staff members for the past 25 years or so. I have found them to be first class professionals who are dedicated to the public interest. While my knowledge of federal government agencies is limited, it would be hard for me to believe that there could be another agency that is as professional and accomplished in performance of its responsibilities than the SEC. I am confident that Chairman Pitt will carry on the distinguished record of the SEC.
Having said that, it is my perception that working relationships between the SEC and accounting professionals had become increasingly strained and even confrontational in the past several years. Based on many conversations with auditors and corporate executives, I sensed a much more cynical attitude on the part of many of the SECís accounting staff members. I also experienced this directly in a couple of cases in which I consulted with companies that had to discuss an accounting issue with the SEC staff. Rather than a spirit of cooperation in order to achieve the most appropriate outcome for the investing public, too often an attitude of "youíre obviously guilty of some wrongdoing if you have to come see us" seemed to have existed when some companies or auditors approached the SEC staff to discuss contentious issues. In fairness to the SEC, some business executives and their auditors and lawyers pride themselves on finding the loopholes in the rules that will allow them to do what they want regardless of the substance of the transaction or the spirit of the rules.
Whatever the cause, the trend has been much more reluctance by companies to seek SEC input on the front end of difficult accounting matters. Recent comments by Chairman Pitt and Chief Accountant Bob Herdman encouraging companies and auditors to talk to the SEC on the front end represents an extremely positive step, in my opinion. While the SEC has enforcement powers to correct reporting that is identified as being inappropriate, it does not have the resources to review all companiesí reports and determine their propriety. It must rely on the private sector (corporate executives and independent auditors) to do the right thing. There must be a high degree of trust among regulators, reporting companies, and auditors for the reporting system to work best. Therefore, I commend Chairman Pitt and Chief Accountant Herdman for their efforts to create a more positive environment in which all interested parties can work together to improve both individual companiesí reporting and the overall system. At the same time, I am confident that the SEC will act decisively when individual companies or their auditors have not performed in a professional manner.
On January 22, the SEC issued FR-61 "Commission Statement About Managementís Discussion and Analysis of Financial Condition and Results of Operations." This release provides SEC views on matters that public companies should consider disclosing in their calendar 2001 and later annual reports. The matters covered relate to off balance sheet arrangements, trading contracts for which fair values must be estimated, and related party transactions. This release closely followed recommendations from the Big 5 accounting firms on those matters, all of which were issues for which Enronís disclosures have been criticized. I believe these SEC recommendations will result in additional useful information to investors and other readers of annual reports. This is an excellent example of how positive interaction between the accounting profession and the SEC can lead to immediate gains to the investing public. Enhancing trust and cooperation between the parties, as the SEC apparently is trying hard to do, is likely to lead to additional positive actions like this one.
It Takes Too Long to Issue Accounting Standards
SEC Chairman Pittís Public Statement announcing his proposal for a new auditing profession oversight board included the following admonition: "We need more prompt action by the FASB, the nationís accounting standard setter." I agree 100% with that comment.
It simply takes too long to develop new accounting standards. When I was appointed as Chairman of the FASB in September 1986, an item in the Wall Street Journal stated, "Mr. Beresford will likely urge the FASB to be more timely in setting standards." While I did try to improve timeliness, I failed miserably in actually moving things along more quickly. We adopted a strategic objective of completing major projects in no more than three years, but even that very modest goal has not been achieved. The recently completed accounting for business combinations project lasted approximately five years and many earlier projects lasted much longer.
The FASB has explained many times that it only deals with topics for which many solutions are highly controversial. Accordingly, it takes a certain amount of time to properly research those matters, debate them among the Board members, and then seek public comment on the preliminary conclusions. Also, the Boardís open due process (including comment periods for constituents to submit their views on proposals, field-testing of proposals, public hearings, and other procedural steps) necessarily adds time.
Those due process steps are appropriate in order to give all interested parties an opportunity to inform the Board about pertinent information relating to the matter in question and to challenge the Boardís preliminary thinking. Such an open process leads to better standards and also contributes to the FASBís credibility in the business community. Thus, efforts to achieve earlier solutions to new accounting challenges should not come at the expense of significantly shortcutting due process.
Rather than reducing its interaction with constituents, I believe that the FASB could reach earlier resolution on many projects by streamlining its internal processes. There are at least three ways in which this could be done.
First, would be for the Board to limit the content of its standards to the most significant matters related to the issues in question. At present, too often the Board members feel compelled to address great levels of detail in order to achieve a standard that answers all possible implementation questions. This is done, in large measure, to try to avoid the possibility of corporations applying a standard in a manner that the Board did not intend (sometimes referred to as "scoundrel prevention"). Dealing with such great detail not only takes more time, it also leads to lengthy and complicated accounting standards that actually may result in less desirable outcomes. Iíll say more on this point later.
Second, would be for the individual Board members to not strive for what they personally believe are conceptually pure answers when doing so would significantly delay finalizing reasonable guidance for practitioners. The Board bases its standards on an underlying conceptual framework, much like the U.S. Constitution is the fundamental base for legislation on specific matters. The FASB conceptual framework is necessarily general in many respects, and when Board members debate topics they often disagree among themselves on appropriate solutions while referring to the same underlying concepts.
I admit to being more of a pragmatist than a theorist. However, I believe that the FASB (as well as other parties involved in establishing guidance for accounting and auditing practitioners) should keep in mind the overriding goal of reasonably prompt problem resolution. Even after five or ten years of effort, reasonable people will disagree as to whether an individual accounting standard is conceptually pure or best serves the needs of financial statement users. A timely answer is better than an arguably more theoretically pure one delivered at a much later date.
A third reason why progress is slow on most major projects at the FASB is the relatively small size of the staff. There are seven Board members and approximately 45 staff members. Nearly all of the research, memoranda drafting, and other technical procedures necessary to prepare a matter for debate by the Board members is performed by the staff. Board members become deeply involved in projects by studying staff memos, reading all comments letters from constituents, deliberating issues in public meetings, and through various other procedures. However, the Board is able to move only as fast as the staff can prepare matters for its consideration.
Increasing the staff by 10-15 people would almost certainly allow projects to be considered more rapidly. This would, of course, require additional funding (see later comments on funding). It would also require finding enough qualified people willing and able to work for the FASB, which has not been easy to do in recent years. Funding and candidate identification are tough challenges, but the FAF Trustees should consider those to be critical objectives in order to allow more timely attention to important accounting issues.
Accounting Rules Have Become Too Complex
Notwithstanding the complexities of todayís business world, one of my major concerns is that accounting rules and regulations have become too complicated and that has added to the burden of those who are reasonably informed and are reasonably diligent about studying corporate reports. Corporate executives and auditors who have direct responsibility for delivering financial reports to the public have a very difficult time keeping up with and understanding all of the accounting rules. As just one example, the FASBís pronouncement on accounting for derivatives is about 250 pages long and a Derivatives Implementation Group met for over two years to develop a few hundred additional pages of interpretive guidance. Iíve heard senior partners of major accounting firms say that only a handful of specialists within their firms are fully conversant with all of the rules on this important topic.
I certainly donít mean to pick on the FASB Ė after all, much of what the Board did on the derivatives project was well along before my term ended. But it does seem as though things have become too complicated and it is time to step back to see if more general standards can work as well or better.
It may be helpful to comment on the genesis of all this complexity. It wasnít always thus. The trend toward more detailed standards resulted, in part, from the attitude of some that whatever was not explicitly required by the rules need not be done, and perhaps more importantly, whatever was not explicitly excluded, was by definition permissible. Others, who may have understood and wished to apply the rules in their much broader context, nevertheless, for competitive purposes, called for "more definitive guidelines" (thus the birth of the term "scoundrel prevention"). However, it seems the pendulum has swung too far.
To a certain extent, the FASB took a step toward more generalized standards in its recently completed standards on accounting for business combinations and goodwill. Those standards are still pretty complicated, but they provide for a considerable amount of management judgment in deciding whether and when the value of goodwill has become impaired, for example. Some parties will, no doubt, call for more rules to specify how to make those impairment decisions and I urge the FASB to continue to resist those requests. The overemphasis on detail will not be reversed overnight. However, over time this is something that I believe the FASB must strive for.
Accounting standards are necessary in order to cause reports by various companies to be reasonably comparable. Similar to the rules of football, without some standardized approaches to accounting, sorting out the winners and losers in the business world would be much more difficult. However, like the compromise over instant replay for NFL games, often the parties involved in the process are willing to accept fewer or less specific rules so that the game flows more smoothly but still within some appropriate boundaries.
In January, the FASB announced that it "... discussed a number of potential projects to simplify the U.S. accounting literature in order to improve its effectiveness and usability." Among the actions that the Board decided to take was to "Evaluate the feasibility of issuing standards that are less detailed and have few, if any, exceptions or alternatives to the underlying concepts." This is a good first step and I look forward to the FASB devoting more time to reducing complexity of accounting standards over time.
Some will argue that if the Board makes its standards more general and limits the amount of detailed guidance they provide, it may lead to more inconsistencies in financial reporting. However, to the extent that the FASB staff, the SEC, accounting firms, or others identify such inconsistencies, the FASB Emerging Issues Task Force can deal with them on a timely basis. The SEC Chief Accountant has indicated a desire to work more closely and cooperatively with the EITF in providing guidance on new issues that demand quick attention. The FASB should keep this in mind and be willing to limit its standards to more general approaches in the future.
The Consolidation Project and SPEís
In spite of the fact that the real accounting issues in the Enron matter had to do with a lack of substance in certain transactions, attention has centered on the accounting for SPEís largely because they were the vehicles used to obscure the transactionsí substance. Originally, the SPEís were accounted for "off balance sheet," which means that the entities were not included in Enronís consolidated balance sheet, income statement, and other financial statements. Subsequently, the company restated its information for several years to consolidate those SPEís with Enronís other assets, liabilities, revenues, expenses, etc. The result was a significant increase in the liabilities reflected in Enronís balance sheet and a significant reduction in Enronís net income for those earlier years.
The FASBís Emerging Issues Task Force developed the existing accounting guidance for SPEís about ten years ago with considerable input from the SEC accounting staff. The need for this arose because the existing authoritative accounting guidance on consolidation related primarily to situations involving ownership of voting interests. The general rule was then, and is now, that entities in which a corporate parent owns more than a majority of the voting equity interests should be included in consolidated reports. Those entities for which ownership was 50% or less generally are not included in consolidation (are off balance sheet). (In the case of SPEís, to qualify for off balance sheet treatment the sponsor must own no equity in the SPE. At least 3% of the capitalization of the SPE must come from unrelated parties Ė the remaining 97% generally comes from borrowings from financial institutions. Thus, the 3% of capitalization represents 100% of the equity ownership of the SPE.)
Many parties believe, however, that there are situations where one entity "controls" another even without majority stock ownership. The FASB has been working to develop a definition of control and implementation guidelines for at least fifteen years (since Statement 94 on consolidation of majority owned subsidiaries was issued in 1987). Two separate exposure drafts of proposed new rules for consolidation based on control were issued for public comment but most constituents vociferously opposed them, and they were not adopted as final rules. Many of the comments on the most recent proposal urged the Board to defer consideration of the broader control/consolidation matter but work to develop better accounting for the increasing number of special purpose entities. A few months ago the Board agreed that it should concentrate its near term efforts related to the consolidation project on SPE matters. According to the Boardís most recent Technical Plan, it expects to issue proposed new guidelines in this area no later than June 30, 2002.
Why has it taken the FASB so long to resolve this matter? Iím not sure that I have a fully satisfactory answer to that question. However, let me mention some of the concerns I had with the control notion during the time I was at the Board, as well as subsequently when I sent my own comment letter on the latest proposal to modify general consolidation requirements.
Control is a hard notion to define in a way that can be applied consistently in practice. Relatively early in my time at the FASB I remember a meeting where we discussed the project in an open meeting with SEC Commissioners. David Ruder was the new SEC Chairman at that time. When we brought this matter up I recall Chairman Ruder saying something like, "Good luck - the SEC has been wrestling with the definition of control since the 1930's and we still aren't satisfied we've gotten it right." The FASB was convinced at that time that it could "get it right" but many years of subsequent debate have proven Chairman Ruder to be quite prophetic. With each iteration of definition and supporting implementation guidance, the Board has ultimately concluded that consistent application in practice was unlikely.
Beyond these implementation challenges, there is the matter of what reporting actually best serves users of financial statements in this area. Should all corporate relationships somehow result in consolidation? I donít want to bury Committee members in accounting esoteria, but let me give one example.
Should a real estate operator have to consolidate all of the limited partnerships in which it serves as the general partner, even when its interest in each partnership is only 1%? If that were done, the consolidated financial statements would show large amounts of assets, liabilities, and "minority interest" and only a small amount of stockholders' equity. The income statement would show large revenues, expenses, and then a line called "less minority interest" to arrive at a small amount of net income. The statement of cash flows apparently would show all of the cash receipts and disbursements of the limited partnerships, even though nearly all of the consolidated cash wouldn't be available to the "parent." Many knowledgeable accountants and financial analysts have said that this would not be meaningful or informative reporting.
The matter above is what I would call a more general consolidation accounting matter. The SPE matter is a specific application. Until very recently, most FASB Board members believed that it was inappropriate to deal with a narrower topic (i.e., SPEís) without resolving the overall consolidation matter.
Consolidation is only one matter relating to the overall topic of so-called off balance sheet financing. Off balance sheet financing represents a very broad and challenging accounting matter. Unfortunately, there isnít even a common definition of this term of which I am aware. However, it probably would include such matters as SPEís, leases, take or pay contracts, through-put arrangements, and many more situations where a company will be able to use something in its future operations in exchange for agreed upon payments.
At the extreme, this could include simple executory contracts, such as the University of Georgiaís agreement to employ me for the 2002-03 school year. Should Georgia record an asset for the "value" of my future services and a liability for the amount the University has agreed to pay me? Most accountants probably would say no, because this contract involves both future services and future payments. But that is also the case for most of the off balance sheet financing arrangements that have been criticized recently.
The accounting problem is to agree on what represents an asset and what represents a liability, and when such amounts should be recorded in balance sheets. Some of these arrangements are treated as assets and liabilities under current GAAP, such as capital leases and SPEís that meet consolidation rules. For many other arrangements, the future cash obligations need to be disclosed in financial statement footnotes even if assets and liabilities are not recorded in the balance sheet.
I have heard more than one commentator on the Enron matter say that we must record all of "these" contracts as liabilities. However, Iíve yet to hear one of those commentators say exactly what she or he means by "these." The new disclosures recommended by the SEC to be included in Managementís Discussion and Analysis will provide additional information beyond what is already required by GAAP, and that is a positive step. The FASBís current attention to SPEís also is a positive step. However, it is important that the broader off balance sheet financing matter be studied carefully before cluttering up corporate balance sheets with amounts that might provide little or no incremental information to users, and may even confuse them.
A key reason why many of these arrangements are allowed to be kept out of balance sheets at present is that the company does not own the asset in question. A third party has legal title to the asset and has agreed to make it available over time to the company. If you have signed a lease for an apartment in Washington for the next year, do you consider that to be an asset? I suspect that most of you do not, and corporations often feel the same way about their future obligations.
In the debate about consolidation, it is important to keep the bigger picture in mind. Would consolidation of more entities actually improve usersí understanding of a companyís financial position and results of operations? In the vast majority of cases, including more entities in consolidation would have negligible effects on net income for the reporting company. It would increase both the assets and liabilities in the balance sheet and change certain ratios, particularly debt to equity. (The Enron situation, involving a very substantial adjustment to net income through consolidation of three SPEís, was fairly unique Ė caused by the reversal of gains on things that Enron had sold to the SPEís or on "hedges" that didnít provide real economic protection.)
Some would argue that more information is being provided to careful readers of financial statements under current GAAP as compared to what might result from more consolidation. This is because companies must disclose in footnotes certain information about entities in which they have a significant ownership interest but less than necessary to require consolidation. If all of those entities were consolidated, the individual amounts would become buried in the parentís balance sheet numbers, the footnote disclosures would no longer be presented, and the results would arguably be less meaningful.
A Few Comments on International Accounting
To some extent the degree of detail in accounting standards has been described as general vs. detailed, or principles vs. rules-based. A recent article in Business Week suggested that the off balance sheet financing vehicles used by Enron would never have been allowed in the first place under European accounting. The article noted that the new International Accounting Standards Board is using a principles approach and avoiding the U.S. tendency toward very detailed rules. Applying principles, auditors in Europe supposedly would have been able to stand up to clients and insist that SPEís be accounted for on balance sheet. Further, according to the December 13, 2001 issue of Accountancy Age (a United Kingdom publication), "Sir David Tweedie, International Accounting Standards Board chairman, and Allan Cook, UK Accounting Standards Board technical director have indicated Enronís collapse could not have happened under existing UK or global rules." Mr. Cook also was quoted as saying, "The IASB would probably have got it on the balance sheet."
In evaluating such remarks, you and others should keep in mind that Enron corrected its financial statements to consolidate the troublesome SPEís in order to comply with existing U.S. GAAP. Further, any such remarks about other countriesí accounting standards must be considered in the context of the rigor of auditing practice and regulatory enforcement, for which U.S. practice is far superior to the rest of the world.
As stated earlier, I am in favor of less complicated and less detailed accounting principles, which is the approach being pursued by the IASB. That said, it is important to note that, on balance, our U.S. financial reporting system remains the best in the world because of the combination of comprehensive accounting principles, required audits by independent accountants, and regulation and enforcement by the SEC. No other country or area of the world has an overall system of financial reporting that is as reliable and informative as ours.
The IASB activity should be commended and supported by U.S. parties. At the same time, I believe it is imperative that neither the SEC nor the FASB take action in the near term that would have the effect of watering down generally accepted accounting principles in our country. Convergence of accounting standards around the world is an admirable long-term goal. However, for the next five to ten years, at a minimum, we must not dilute U.S. reporting solely for the purpose of harmonization.
Funding of the FASB
One of Arthur Levittís recommendations in his New York Times op ed piece is that alternative funding be put in place for the FASB in order to improve its independence from the business community and accounting firms. This would allow the organization to cover its operating expenses through a "broad based user fee," in Mr. Levittís words. A number of alternatives for funding the FASB have been suggested in the past and this matter is certainly worth further consideration by the Trustees of the FAF and other interested parties.
At present, approximately two-thirds of the FAFís annual budget comes from selling publications and similar operating activities. The remaining one-third represents voluntary contributions made by the AICPA, individual accounting firms, and approximately 1,000 corporations. The total contributed by corporations represents about 15% of the FASBís budget in total, and individual amounts generally do not exceed $50,000 (the vast majority are much less). Corporations occasionally threaten the FASB that they will cease contributing if the Board adopts a certain technical position. By and large, however, the number of donors who actually do this is very small.
One suggestion that has been made in the past is that permanent funding should somehow be put in place. To cover the current operating needs of the FASB and GASB would necessitate a permanent endowment fund somewhere in the neighborhood of $300 million (the FAFís current reserve fund is about $29 million). It is unlikely that corporations, accounting firms, investment bankers, and others directly involved in the FASBís activities would be interested in or able to provide this level of funding. Perhaps Congress could find a spare $300 million lying around, but most parties believe the strings likely to be attached to any such funding would undermine the private sector nature of the Board.
Another possibility would be for a fee to be assessed on all public companies and perhaps other parties interested in the financial reporting process, such as accounting firms and investment bankers. This apparently is what Mr. Levitt has in mind. If this could be done through the stock exchanges or in some other way that does not involve the government, this idea might be worth pursuing. However, it is more likely that the SEC or even Congress would have to get involved in this kind of arrangement and such a relationship to the FASBís funding would be detrimental to the Boardís independence. An advantage of the present system is that having some dependence on voluntary contributions means that the FASB is subject to a sort of market test of its effectiveness. The Boardís technical actions are, and should be, independent in nature. However, it is also important that the FASB not be so distanced from its constituents that too large a number of them become unwilling to continue financial support. Most contributing accounting firms and corporations recognize that they are not going to get their way on technical issues just because they make a contribution. But if the Board begins acting in a way that somehow ignores the input from constituents, the contribution mechanism is a way for them to express their significant dissatisfaction.
To be clear, no contribution to the FAF, or threat of withholding a contribution, affected any of my decisions at the FASB in any way whatsoever. And I know that that was true for all of the individuals with whom I worked at the Board.
As noted earlier, I recently became the chairman of the audit committee of a public company. Even before doing this I had worked with a number of audit committees while I was still in public accounting and I have consulted with some committees in my present position. Based on these experiences, I believe that audit committees can and do serve an important function in the financial reporting system. And I was particularly pleased to see the changes over the past few years that require audit committee members to be independent board members and require those members to be reasonably qualified for their responsibilities.
While audit committees play an important role in the reporting system, they do not have primary responsibility for appropriate financial reporting. That duty rests with corporate financial management, and independent auditors play a critical part as well. But the audit committee can set an important tone at the top. Audit Committee members also can ask tough questions of management and outside auditors, and demand answers that are understandable to them. But even the best audit committee is not going to guarantee that a financial reporting problem will not occur.
There is one area where I think audit committees can be improved. That is in the qualifications for membership. While all members are presently required to be "financially literate" and at least one must have "accounting or related financial management expertise," I believe those requirements can be clarified and strengthened. At least a majority of audit committee members should have significant accounting, auditing, finance, or legal expertise. General management responsibility without direct involvement in one of those areas should not be sufficient for those individuals.
Also, the person with "accounting or related financial management expertise" should have strong skills in that area. Since the introduction of the new audit committee membership requirements, it appears as though there has been only a trickle of new board member appointments from backgrounds as chief financial officers or controllers of corporations, or as audit partners from accounting firms. Making these requirements more stringent could encourage companies to invite more individuals with CFO/audit partner background to join their boards. And adding legal expertise to audit committees could assist committee members in understanding the complex organizational and transaction structures employed by many companies today.
Significant accounting, auditing, finance, and legal expertise are essential prerequisites for members so that the complex issues that may be presented to them will not intimidate them. Members with such qualifications are more likely to ask management the probing questions necessary to ensure an understanding of the substance of the issues brought to their attention. In particular, members with audit expertise will be better able to effectively judge the performance of the internal and outside auditors.
Raising the bar for audit committee membership will not by itself protect against future Enrons, but it should certainly help improve the overall quality of financial reporting.
To summarize, this is a critical time for financial reporting and the auditing profession. It is important that the issues raised by the Enron matter and other recent business/accounting/auditing failures be studied and used to evaluate what changes can be made to improve the system. However, it is equally important that the baby not be thrown out with the bathwater. The current system is not foolproof but it works well in the vast majority of cases. Consideration of changes should call attention to and build on the strengths of the current system rather than undermining it.
My principal suggestions for improvement are as follows:
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