1000 WORD ESSAY

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COMMENTARY

John I Smith

John T. Smith is a Partner at Deloitte & Touche LLP.

Responding to FASB Standard-Setting Proposals

INTRODUCTION We develop our responses to Financial Accounting Standards Board (FASB) stan-

dard-setting proposals by obtaining input from a number of partners; primarily from the technical group in the National Office, but also from client service partners in the field—particularly specialists in the area under consideration. We generally do not at- tempt to explore broad alternatives, unless we disagree conceptually with the proposal or have significant reservations about its operational aspects. Due to the diverse back- grounds and perspectives of the participants in the input process, our initial views fre- quently are not uniform. Differences in views are debated with the goal of arriving at what we consider to be the most appropriate response. In developing our response, we consider the extent to which the proposal will change practice and the implications of that change.

We have attempted to improve our process of assessing standard-setting initiatives by identifying a number of broad fundamental areas for consideration and establishing evaluation criteria for these areas. We recognize that it is not possible to develop an approach that could be used to fully and objectively assess the merits of a proposed standard. However, we believe the use of a methodology that focuses on certain funda- mental aspects of any standard-setting proposal may improve the process. The purpose is to produce a more organized, uniform and consistent approach to evaluate proposals and to provide a foundation to test and validate the rationale for our conclusions and recommendations. The approach that we have started to use, and are continuing to develop, focuses on three fundamental aspects inherent in any standard: economics of transactions; concepts used to portray the economics; and rules used to make concepts operational.

Understanding the economics of transactions contemplated by a proposed standard is an essential part of the analysis process. Determining whether there are competing economic views of these transactions is psirticularly important in evaluating the con- cepts that are selected to portray the transactions and the usefulness of the information to be reported in financial statements. Ideally, the concepts selected should be based on economic logic, portray the most pervasive view of the economics, and be applied com- prehensively. Evaluating the rules used to make concepts operational and limit alter- natives also is an important part of the process. Ultimately, support for a proposed

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standard becomes a judgment that broadly considers whether the proposed standard provides information that is useful, improves practice, and is operational. The rationale for these considerations is described more fully below.

THE OBJECTIVE OF FINANCIAL STATEMENTS FASB Concept Statement No. 1, Objectives of Financial Reporting by Business

Enterprises, provides the basis for assessing standsird-setting initiatives. It states: "Fi- nancial 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 recommendations of the AICPA Special Committee on Finan- cial Reporting also focus on the needs of users to value and assess the risks of their investments.

The message is clear—the objective of financial reporting is to provide information that is useful for making decisions. However, there are a number obstacles that make it difficult to determine whether this fundamental objective is being met and can be fully achieved.

SERVING THE NEEDS OF USERS Based on the FASB objectives, it is clear that the overriding consideration in the

development of standards (and in any response to a standard-setting initiative) should be to ensure that standard-setting proposals will provide more useful information to users of financial statements. If the needs of users were fully understood, evaluating standard-setting proposals would be easy. It is difficult, however, to determine what their needs are and whether the objective is being satisfied. In addition, it is impossible to determine how useful the messages conveyed in financial statements are, or will be, to the users of financial statements, as a result of stsmdard-setting proposals.

The objectives in the FASB Concept Statements are directed toward the common interests of many users. However, users will understand and interpret information differently. They have different levels of sophistication and knowledge, different cash fiow needs, and employ different trading and investment strategies. They may inter- pret the same information differently, or focus on different information and assign greater significance to certain information and less significance to other information. Perhaps, information that is important to some users is not important to others. The Association for Investment Management and Research's Position Paper, Financial Reporting in the 1990s and Beyond, recognizes the difficulty of identifying user needs. It cites the mini- mal amount of empirical research about users' needs, and observes that much of what is written merely speculates about what would or would not be useful to users.

In the absence of obtaining an understanding of user needs directly from users, judgments can be made about the qualities that are necessary to fulfill the objectives by focusing on some of the guidance in the FASB Concept Statements. The Concept State- ments indicate that relevance and reliability are the two primary qualities that make accounting information useful for decision making relevant, in that it is timely and has predictive value; reliable, in that it has representational faithfulness, is verifiable and neutral. These conditions are subject to cost-justification and materiality considerations.

The qualities necessary to making accounting information useful also require a need to portray economic reality. A more direct focus on economics is contained in Concept Statement No. 1, which specifies that the information provided in financial reporting should be comprehensible, and should help in assessing cash flows, economic

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resources and obligations, as well as owner's equity and financial performance during a period. To be meaningful, standards should provide information that makes transac- tions, rights and obligations understandable. Understanding is facilitated if the infor- mation depicts economic reaUty, discloses critical activities, and conveys standardized information in a clear and unambiguous way. The key emphasis, however, should be on economic reality.

EVALUATING STANDARD SETTING PROPOSALS Assessing the Economics

Develop an understanding of the economics of transactions contemplated by the pro- posed standard and determine the extent to which there are competing economic vietvs. Determine whether there is a prevailing view of the economics and whether the proposed standard accurately depicts that view.

The most important factor to consider in deciding whether financial information is decision-useful is the extent to which it reliably depicts the economics of transactions. It is understood that financial accounting is not designed to measure directly the eco- nomic value of a business, so the accounting and the economics will not necessarily follow each other.

However, financial accounting is intended to provide information that is useful to those who desire to make their own estimates of the enterprise's value. When the ac- counting depicts the economics, the results of transactions have meaning and generally can be understood. The reverse is true if the accounting does not depict the economics. If the economics of transactions are faithfully represented and presented, users then can decide the extent to which certain economic events affect their decisions. The AIMR's Position Paper, Financial Reporting in the 1990s and Beyond, states "analysts need to know economic reality—what is really going on—to the greatest extent it can be de- picted by accounting numbers."

The portrayal of economic reality is an important objective, but it is an ideal that is not fully achievable. Just as users do not evaluate the usefulness of infor- mation in the same way, in many instances, there are different views about the substance and economics of transactions. For example, when an entity makes a loan to another entity, the economics are clear—one party has an asset, a receiv- able; the other, a liability to repay the loan. However, if the party making the loan transfers a portion of it to another party and guarantees performance of the bor- rower, the economics are not clear. Some may view the second transaction eco- nomically as a sale, while others may view it as borrowing. Sometimes the econom- ics cannot be fully assessed; for example, when the outcome is dependent on uncer- tain future events.

Providing Comparability Determine that the use of concepts and rules in the proposed standard narrows al-

ternative accounting choices and improves comparability. When there is general agreement about the economics of transactions, broad ac-

counting guidance consistent with the economics is usually sufficient to ensure compa- rability of reporting. Detailed or rigid accounting guidance is generally not necessary to reduce accovmting alternatives because there is a tendency to challenge any accounting result that does not accurately depict the economics. When there are different views about the economics of transactions, there is a greater need for focused accounting

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guidance. There also will be a tendency to find a way to interpret any accounting guid- ance provided in the standards to accommodate the perceived view of the economics.

An ability to choose from dtemative accounting treatments, based on individual perceptions of the economics, would permit like transactions to be portrayed differently in financial statements, which is undesirable because it reduces comparability and is likely to confuse users of financial statements. The use of a concept or a rule to limit the alternatives ensvu-es that like transactions will be accounted for the same way and that standardized accounting for such transactions will increase understanding and compa- rability and avoid confusion.

Balancing Concepts and Rules Determine whether the proposed standard is primarily concept-based or rule-based.

Assess the appropriateness of the balance between the use of concepts and rules used to provide guidance.

Concept-based standards are considered to be superior to rule-based standards. The accounting result from appl3dng a concept is usually more understandable and transparent than the result of applying a rule. Rules generally are more arbitrary, and the results of their application require more interpretation than concepts. A concept may be considered to be arbitrary when it is selected to depict one of the competing views of the economics, but the underlying economic rationale enables a concept to accommodate a wide variety of transactions and produce consistent and reliable ac- counting results. The applicability of concepts to a wide variety of transactions enables them to be used over long periods of time without requiring the standard to be changed to accommodate new transactions, or variations of transactions, not initially compre- hended in the development of the standard. A low-maintenance standard provides greater comparability because it does not require continuous updating for interpretations, and for new transactions not comprehended by the initial guidance.

Standards that are concept-based are not as susceptible to manipulation and abuse as standards that are rule-based. Although conceptual guidance requires judgment in applying the concept that, in turn, provides the potential for misapplication, the eco- nomic rationale embraced by the concept serves to limit the extent to which it can be misapplied. Rules preclude the use of judgment, and thereby reduce the possibihty for misapplication. However, they have the potential to be abused through careful struc- turing of transactions to take advantage of the rule.

Although guidance based on a concept is generally preferred, such guidance by itself would rarely be sufficient to ensure a consistent application of a standard. Rules are neces- sary to make concepts operational. Sometimes it is not to possible to identify a strong pervasive concept that can be applied to a variety of transactions. In these situations, greater reliance has to be placed on rules to limit alternatives and to provide comparability of results. There is no objective way to determine when a rule should be used in place of a concept. Judgment is required to assess the appropriateness of the balance, recognizing that there is a continuum with concepts at one end and rules at the other that, near the extremes, are both inappropriate. Accounting guidance has to be provided using both con- cepts and rules. The appropriateness of the balance between the concepts being employed and the rules needed to implement the concepts is often difficult to assess objectively.

Selecting a Concept Obtain an understanding of the concepts being adopted in the proposed standard,

and determine whether they are explicitly identified and explained therein. Assess the

Responding to FASB Standard-Setting Proposals 167

appropriateness of the concepts being adopted. Determine whether the accounting result from applying the concept can be explained easily and understood in terms of the eco- nomic view being selected. Consider the alternative competing economic views, and whether the concept selected to depict a particular view is considered superior to the other alternatives.

A concept is often adopted in a standard to serve as a basis for depicting transac- tions under the scope of the proposal. It is also used to decrease the confusion that may result from allowing the accoxmting to be based on a selection of any of the competing economic views. When economics are not clear, a concept should be chosen to represent one of the competing economics views and, if determinable, the one considered to be the most appropriate in the circumstances.

For example, the concept of control is used in SFAS No. 125, Accounting for Trans- fers and Servicing of Financial Assets and Extinguishments of Liabilities, as the basis of determining whether a sale or financing has occurred. A risks-and-rewards approach had been used previously, but it was considered by some as not being operational be- cause it provided for considerable free choice. When a concept is used, it should form the basis for explaining the accounting result and making it understandable. A concept should bring logic and order to transactions. And it should make sense on its own with- out the need for detailed interpretation. It should produce a result that is explainable and understandable in terms of the economic view being adopted.

Articulate the Concept. The concepts being adopted can best be understood if they are explicitly identified in the proposed standard. If the concept is not clearly established as the foundation for the standard, the rules specified in the standard used to implement the concept tend to be viewed more as arbitrary requirements instead of applications of the concept. In these cases, structuring around the rules used to make the concept operational may be considered appropriate to attain a desired alternative accounting result. When a concept is clearly specified, it is more difficult to circumvent it by evaluating the strict compliance with rules. Compliance is assessed more auto- matically and appropriately against the concept and spirit of the stemdard, not to the rules used to make the concept operational.

Link the Concept to the Economics. The economic basis for selecting a concept should also be clearly and formally specified in the proposed standard for every concept that is adopted. Concepts should logically follow an economic framework and be consis- tent with market reality of the applicable transactions. The economic rationale should be explained and justified to reduce any confusion that may otherwise exist. If the concept is confusing, or produces confusing results, there will be a tendency to find alternative accounting solutions that make better sense and can be explained. As a result, there will be a significant dependence on detailed rules to reduce diversity from the potential misapplication of the concept. A concept would be considered inappropri- ate if it produces a convoluted, meaningless or an unintelligible depiction of economics or is a clear compromise of the economics. If a concept is not clearly linked to the eco- nomics, it is not likely to be operational because its implementation will rely on judg- ments that are too subjective.

Select the Superior Alternative. Just as competing economic views should be identified, competing concepts also should be identified to determine whether the con- cept selected is superior to the others. Generally, the concept selected should portray the prevailing economic view, if it is determinable. A concept may be considered appropriate if it can provide a more precise or reasonable depiction of an economic perspective, or a more understandable economic result than other concepts. A concept

168 Accounting Horizons / June 1998

also may be considered appropriate if it can be made operational with much less diffi- culty than other concepts.

If the concept selected is not generally considered superior to other competing con- cepts, or if it is not founded clearly in an economic perspective, it may be viewed as being adopted arbitrarily, solely as a basis for eliminating diversity. In this instance, the concept loses some of its effectiveness, and is viewed and applied more like a rule that is selected arbitrarily.

Ensure Comparability and Consistency. Concepts should be capable of being applied comprehensively and consistently to a multitude of transactions. If there are exceptions in the application of the concept—for example, to accommodate a particular practice for certain transactions—the concept loses some of its effectiveness because there will be analogy to the exempted transactions to achieve an alternative accovmting treatment. The concept also should be consistent with other accounting literature. If it confiicts, it will create confusion, because similar transactions may be analogized to the conflicting literature to achieve a different accounting result. Sometimes, however, it may be necessary to permit a conffict with other accounting literature, when a new concept is being applied to certain transactions, but the concept is not developed fully enough to be applied on a wholesale basis. In these circumstances, the standard should clearly specify that analogy to other literature is inappropriate.

Specifying Rules Rules are used to supplement concepts. They should provide sufficient guidance to

make the concepts operational, but they should not be excessive. A concept clearly founded in economic rationale reduces the need for rules. Guidance in the form of rules should be developed in the proposed standard by reference to the concepts being used to provide meaning to the rules. Rules also are used to limit alternatives and provide comparabil- ity. If rules must be established arbitrarily to reduce alternatives, they should be simple to understand and apply.

Rules are needed to make concepts operational. When a standard is based on a clear concept, it can be made operational with few rules. The unnecessary use of rules, or the use of rules that are not clearly linked with concepts, tends to diminish the concepts being used, making them less effective and more difficult to understand. When rules overshadow the concept that was developed, or are used as a basis for the account- ing, they weaken the effectiveness of the standard because it is perceived as being arbi- trary or form driven. For example, as discussed previously, SFAS No. 125 is based on a concept of control. However, there are a number of rules used to make the concept operational to determine whether a transfer of control has occurred, and the rules are written primarily from the perspective of the transferee, not the transferor. Some prac- titioners primarily look to the form or rule as the prevailing guidance without consider- ing the concept, which leads them to conclude that a sale has occurred if a transferor gives up legal control—even if economic control is retained, as in the case of a deep in- the-money "put" held by the transferee. For this reason, it is important to ensure that the concepts are being emphasized so that they are not being obscured by the rules.

Rules also are used to provide a uniform basis of accounting when there is no clear concept that can be applied, and when concepts are not sufficient or fully developed. Rules increase comparability by limiting accounting alternatives. However, the use of rules that are not linked to concepts is not desirable because rules are often considered to be arbitrary, and they are criticized for producing statistics and conformity without a

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purpose, with illogical economics and irrelevant results. The use of arbitrary rules is also criticized because such rules can be interpreted rigidly and applied literally, which permits abuse. Arbitrary rules provide considerable freedom in which to interpret situ- ations not specifically covered by the rules.

When it is necessary to use a rule to limit accounting alternatives, and the rule cannot be linked with a concept, it is often very difficult to ensure that it will be effec- tive in accomplishing its intended purpose and cannot be abused. However, a number of factors can ensure that a rule is operational and effective. The rule should be clearly articulated, easy to understand and easy to implement. If instructions are too vague, the rule can be misapplied or applied on a basis inconsistent with the intent of the standard. In addition, the rule should be practical and cost-beneficial. It should not be over-engineered for the problem or contain too many arbitrary "bright" lines. And it should not require a high cost of compliance. A rule that is clearly arbitrary or a com- promise should be simple. There generally is no valid reason to complicate such a rule, unless it is necessary to prevent manipulation and abuse through selective application or avoidance, structuring and inappropriate analogies.

Rules should not confiict with concepts or other rules. They should be internally consistent. Confiicts in a stsuidard permit different results to be obtained depending on which part of the standard is being referenced. This tends to undermine the concepts being used.