1000 WORD ESSAY

© 1998 American Accounting Association Accounting Horizons Vol. 12 No. 2 June 1998 pp.177-183

COMMENTARY

L. Hal Rogero

L. Hal Rogero is Assistant Corporate Controller of the Mead Corpora- tion and is the chair of the Financial Reporting Committee of the Institute of Management Accountants.

Characteristics of Higii Quaiity Accounting Standards

OVERVIEW In considering the topic to be discussed, the natural tendency would be to focus

solely on determining the appropriate characteristics of the "content" of accoxmting standards. The IMA believes that developing high quality accoimting standards is as much a function of having the right "process" as it is having the right content. In our view, the characteristics of high quality standards establish the vision or the ultimate goal of standard setting, and the research methods that support the process enable the Board to realize the vision and attain the goal. Even if the FASB were to develop the ideal characteristics of high quality accounting standards, its ability to deliver on that commitment would be significantly handicapped by a weak or ineffective process. Ac- cordingly, we have organized our comments into those two categories of suggestions.

We know from our own experience that it is one thing to identify content and pro- cess characteristics that make for a high quality product; it is quite another to integrate them into the way that "business" is routinely conducted. We have therefore included a brief conclusion to our paper that provides our advice to the Board on what should be done with the characteristics that result from the Conference discussion.

PART 1: CONTENT 1) Standards should be written in a clear, understandable manner, and

their principles should be operational to apply. The pace of change within corporations continues to accelerate, and accountants

are increasingly being asked to play many different roles, thereby reducing the portion of their time devoted to accounting and fingincial reporting matters. For example, in well-managed companies the accounting staff is expected to be an integral part of a multifunctional business team, which focuses on corporate operating and strategic is- sues. It is therefore important that standards facilitate a quick understanding of the requirements and can be implemented in a straightforward manner. We suggest the following as principles that will help the Board achieve that goal.

Comments from the Financial Reporting Committee of the Institute of Management Accountants at the AAA/FASB Financial Reporting Issues Conference.

178 Accounting Horizons/June 1998

To the Extent Practicable, Base the Standard Upon Concepts Statements based upon a concept, or imderl5dng theme, are easier to implement

and explain than standards that represent a list of do's and don'ts. No standard can anticipate all questions, but the unanticipated questions are much easier to resolve in practice if the standard has an underlying objective or concept. It is also very helpful to explain and illustrate the concept by providing examples of its application to situations that are likely to occur in practice.

Make Use of Existing Information, When Possible Standards that leverage information used by management to run the business tend

to be easier to use and less costly to provide, and are generally found to be more rel- evant to all involved. In addition, since the information is developed to aid in business decision making, it is reasonable to assume that the information would be more reliable than similar information developed solely for external reporting.

Accept Pragmatic Decisions on Accounting and Disclosure Requirements Standards must strike an appropriate balance between the development of require-

ments that are a pure application of the concept and measurement alternatives that accomplish essentially the same result but are significantly less complex and/or more cost-effective to implement. A pragmatic approach recognizes the value of developing cost-effective requirements and reflects a willingness to sacrifice a degree of precision in circumstances where implementation costs can be significantly reduced or operationality of the document can be significantly improved.

Provide Operational Transition Requirements The time between the issuance of a final standeird and its effective date is frequently

punctuated by frantic activity on the part of companies and auditors to imderstand and determine how to apply the new rules. It is important to recognize that for many com- panies the issuance of a "brown cover" represents their first exposure to the principles of the new standard. With those thoughts in mind, we suggest that both the method of transition and the lead time provided for effective dates represent pragmatic decisions that sometimes involve trade-offs between preparers and auditors on the one hand and users on the other. Standards need to diligently weigh the evidence and strike an ap- propriate balEince between those competing needs.

Ensure that the Benefits that Inure from the Principles of a New Standard Exceed the Possible Costs

We recognize that cost/benefit considerations aie among the most difficult judg- ments to make in developing a new standard. Nevertheless, it is vital that the Board advance the state of the art in this area even if it is qualitative in nature. Toward that end, it would be helpful to constituents if an explicit analysis of costs and benefits were included in the basis for conclusions.

2) Standards sbould provide recognition and measurement guidance that seeks to replicate the "economics" of the underlying transaction or event. Preparers, auditors and users find standards more compelling when the require-

ments follow a widespread view of the "economics." We hasten to add that our position

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is not an endorsement of a fair-value accounting model. Rather, it is a belief that stan- dards should require use of measurement attributes for assets and liabilities that are consistent with their intended use including, where appropriate, historical cost.

We consider the use of different measurement attributes that are appropriate for the asset or liabihty in question to be a strength of the current model rather than a weakness. Further, we beheve that as changes in the model are contemplated, the Board should seek to accommodate historical cost measures when that basis is most consis- tent with the underlying business purpose for holding an asset or incurring a liability. Stated another way, we believe that there continues to be an important role for histori- cal cost in the current model and believe that a high quality accoimting standard appro- priately distinguishes between circumstances in which measurement at fair value or historical cost should be required. It is insufficient, in our view, to require measure- ment at fair value simply "because we can." The following examples may help illustrate these views more clearly.

We agree that it makes sense to measure financial instruments held in trading portfolios at fair value and to recognize changes in their fair values in earnings. The fair-value measure is relevant in this circumstance because the fundamental reason the enterprise holds the portfolio is to maximize gains and minimize losses in achieving its targeted rate of return. Use of fair values internally by management in assessing performance provides further evidence that fair value is the only relevant measure for this kind of asset. In contrast, we do not find it at all helpful to measure debt at fair value in the financial statements of the issuer. Companies generdly do not use fair value information in managing their financial habilities and imposing a requirement to make such a determination would provide little incremental benefit to the enterprise. We believe that the fiuctuations that occur in the fair values of debt obUgations are meaningless since, in the vast majority of cases, they ultimately will be settled at par value. Furthermore, the inclusion of the issuer's own creditworthiness into the valua- tion only serves to compound the problem.

We believe that disclosure is the best place for information about unrealized fair values when realization is controlled by the reporting entity and is unlikely to occur in the near term. We believe that principle should be followed in new stan- dards unless and until financial statement users present compelling reasons why it makes sense to replace historical cost measures in financial statements with fair values.

3) Disclosures should be limited to those that contribute significantly to financial statement users' understanding of tbe enterprise's financial performance. Standards should refiect an appropriate compromise between users' desire for in-

formation and preparers' ability to satisfy that need— încluding the cost of the effort to produce the information and concerns about competitive harm. We believe that the standard-setting process historically has compromised heavily in favor of perceptions of user needs, almost to a fault. The basis for conclusions of most standards treads lightly on how these compromises are crafted; if they are mentioned at all, the basis for new disclosures is punctuated with phrases like "users stated that [proposed disclo- sure] would be useful." If one starts with the presumption that just about any company- specific disclosure can be found to be "useful" in some context, it becomes clear that the universe of possible new disclosures is indeed a target rich environment.

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We can identify several standards issued recently that illustrate the consequences of this phenomenon. For example, while all agree that it is important to have more information available about an enterprise's derivative activities, how much informa- tion is really needed? The collective impact of all of the new disclosures called for by the FASB and the SEC in its Derivatives Release are, in our view, overkill. The eyes of all but a handful of readers will glaze over as they struggle to understand what it all means and, worse, some constituents may actually draw the wrong conclusions from what they read. It seems that some disclosure requirements call for giving to everyone who might ever want to know virtually every bit of information about an issue. We don't subscribe to the "if a little is good, more must be better" theme.

We therefore believe that the disclosure segment of a new standard needs a set of baseline criteria to limit required disclosure to those that bear directly on the invest- ment decision. In our view, this is a much higher threshold than "useful," and it carries with it the responsibility to investigate the specific need that the proposed information will satisfy. Such an investigation should identify the activities conducted by users that involve the subject information, and those activities should ultimately lead to a conclu- sion that bears on the investment decision. If no specific uses or activities can be iden- tified, then the disclosure should not be required. Toward that end, we have identified two categories of disclosure that, in the majority of cases, we believe will not result in information that meets the Eiforementioned test.

Disclosure of Key Assumptions In the context of analyzing the overall performance of an enterprise, there are only

a handful of assumptions that are critical to the determination of future earnings and cash flow. If the company is doing a good job in its financial reporting, these assump- tions are discussed in Management's Discussion and Analysis.

Segmentation of Income Statement and Balance Sheet Categories Financial reporting already has a checklist of categories for which separate disclo-

sure is required for both the income statement and the balance sheet. Proposed disclo- sures that segment this further at the transaction or activity level are a venture into minutia.

Even if the Board decides not to raise the bar higher in considering proposed disclo- sures, we believe that it would be helpful to preparers, and would provide more disci- pline to the decisions about such matters, if the basis for conclusions of a new standard had a more rigorous emd explicit consideration of the merits of the required disclosures. Too often it seems that consideration of new disclosures is more of an afterthought.

PART 2: PROCESS 1) In the absence of compelling evidence of a pervasive problem, new stan-

dards sbould be limited to areas for wbicb tbere are no existing standards. Changes in standards are usually very costly, both in terms of management time

and attention, and in the resources necessary to understand and implement them ap- propriately. In the absence of standards in a particular area in which critical issues are emerging, the reasons for proposing a standard are often much more evident. How- ever, in circumstances for which standards have been in place for a period of time and nothing substantial has changed, effecting wholesale changes to them is less easily justified. Creating revised versions of existing standards raises important and difficult

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cost/benefit issues as the incremental benefit to financial reporting is often elusive. In our view, if the existing pronouncement works well and was based upon well-reasoned principles at the time promulgated, the Board should hold constituent requests for change to a much higher standard before undertsiking a project to revise it.

2) The development of new standards sbould include rigorous and fre- quent participation by task forces and, wbere appropriate, be subjected to well designed and executed field tests before tbey are finalized. As discussed in the February 15,1996 letter from the IMA to the Financial Accounting

Foundation, the IMA strongly supports greater involvement by task force members in the FASB process. We believe that the selection of task force members should be based on their famiharity with the issue at hand, as well as their ability and willingness to attend "drafting" meetings and Board meetings at each important stage in the project. Task forces should develop recommended solutions (recognizing, of course, that only the Board can promulgate standards). We believe that it is terribly inefficient to expect dedicated staff to develop expertise and understanding of complex markets and transactions over a few months or even years when many potential task force members have spent careers devel- oping those same skills. We believe that the Board must aggressively seek task force mem- bers with the core competencies, including users that have direct experience analjraing the subject matter under consideration, necessary for the task force to provide the right infor- mation. The Board should also resist the tendency to call the SEune people to the table simply because they are familiar to the Board and willing to participate. Perhaps, the FASB's Internet web site could be used to advertise open task force positions and seek information about the backgroimds and experience of prospective members.

We also strongly support the use of field tests in circumstances in which the standard's requirements are likely to be very costly and time consvuning to implement, and practica- bility of application of certain requirements is debatable. Oftentimes, the most efficient and cost-effective way to approach development of field tests is to outsource the develop- ment and execution with appropriate oversight, to a knowledgeable third party. Although the FASB often has difficulty getting companies to volunteer to field test new proposals, it should, nonetheless, continue to seek reasonable levels of participation.

3) Tbe development of new standards sbould include tbe consideration of accounting standards in otber countries and seek to leverage opportuni- ties for furthering international barmonization wbere it is feasible witbout compromising tbe quality of tbe U.S. standard. The IMA recognizes that the globalization of the world's capital markets has placed

enormous pressure on standard setters to narrow or eliminate differences between na- tional and international standards. We also recognize that there may well be certain matters where non-U.S. standard setters have guidance that is superior to U.S. stan- dards, and that future FASB standards will more often be developed jointly or in coop- eration with other national or international standard-setting bodies. The IMA fully supports those efforts and agrees with international harmonization as an important objective. That said, we do not support the "harmonization at all costs" objective. We beheve that the FASB must place the needs and concerns of its U.S. constituents above all others. There will sometimes be circumstances tmique to the United States that cause the accounting results of a particular principle to be misleading or otherwise inappropriate. Thus, if the Board is forced to choose between a less-than-satisfactory

182 Accounting Horizons/June 1998

standard that is identical with other national and international standards or develop- ing the best possible U.S. standard, we clearly favor the latter.

4) Standards derived in response to new issues or events sbould constitute a measured response tbat rationally considers tbe importance and pervasiveness of tbe problem. There is a natural tendency in standard setting to view emerging, high profile ac-

counting issues as the single most important issue facing investors at that point in time. In some cases, the extent of the problem is limited to a small group of companies or a handful of isolated control failures. We believe that the standard-setting process needs to protect against standards that overcompensate for the problem and impose costs across the entire private sector.

A case in point is the collective reaction to losses related to derivatives several years ago. The regulatory reaction to those events resulted in promulgation of FAS No. 119, the SEC's release on quantitative measures of risk, and the AICPA-sponsored project on internal controls related to derivatives, as well as changes in the direction and scope of the FASB's hedging project. Many preparer-constituents believe that the relative risks of such instruments are not as significant as the resulting accounting and disclo- sure rules would indicate. Only a few companies were mentioned in the financial press as having big "surprises" over the past several years. Of those financial institutions that had large derivative losses, control and oversight were the real issues. The vast majority of companies have not had similar experiences. And most of the nonbank losses covered in the financial press several years ago were the result of using a highly lever- aged instrument, which, we understand, is no longer in use, at least by most.

5) If appropriate, standards sbould provide for a sunset review of all or a portion of tbe proposed guidance at a futvire date. We think of a sunset review concept primarily in the context of disclosure require-

ments that were deemed useful at the date of issuance but have not proven to be so in practice. However, the Board may also find this concept appropriate for accounting as well.

6) Standard-setting projects sbould have realistic goals for deliverables and tbey sbould be completed on a timely basis. This perhaps goes without saying. The longer a project drags on, the more ingrained

practice becomes and the more difficult the adjustment to implement a new approach.

CONCLUSION We are encouraged by the proactive consideration of this issue by the FASB. We

believe that the outcome of the discussion that will take place at the Conference should provide useful guidance about how the Board can make its process more effective and sharpen its focus on the attributes that make high quality standards.

However, to be successful we believe that the FASB must integrate content and pro- cess improvements into its everyday activities and then regularly measure the effect of such improvements to determine progress. We therefore suggest that the output or deliv- erable from the discussions that took place at the Conference in December ought to be a set of parameters that all constituents believe are critical to quality (CTQs). We would then recommend that these CTQs be integrated into project planning and evaluation.

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One way in which this could be done is by incorporating a feedback mechanism into each proposal or other major activity. The mechanism can be as simple as a short ques- tionnaire that lists each of the CTQs and asks constituents to provide feedback on their perceptions; in fact, this questionnaire could be an interactive form on the FASB's Internet web site. We recommend that the Board solicit input in this manner at key points dur- ing its due process (staff drafts, preUminary views, exposure drafts). This will provide a means for the Board to obtain feedback on the extent to which the desired characteris- tics are present in a proposal.