1000 WORD ESSAY

© 1998 American Accounting Association Accounting Horizons Vol. 12 No. 2 June 1998 pp.188-191

COMMENTARY

John K. Wulff and Susan Koski-Grafer

John K. Wulffis the CFO with Union Carbide Corporation and Susan Koski-Grafer is Vice President-Technical Activities with the Financial Executives Institute.

Characteristics of Higii Quaiity Accounting Standards: Perspective

of the Corporate Preparer The U.S. Committee on Corporate Reporting (CCR) of the Financial Executives

Institute is a national technical committee composed of approximately 40 CFOs, con- trollers and other senior financial executives of public reporting companies. CCR and its various subcommittees meet regularly to track accounting and reporting issues and develop responses that present the views and concerns of the business community as represented by our members. The authors participate in the work of this committee.

Financial Executives Institute (FEI) is a professional organization of over 14,000 senior financial executives in approximately 8,000 public £ind private companies in the United States and Canada.

CCR appreciates the opportunity to contribute industry perspectives in examining criteria for high quality accounting standards. We view our participation in this dia- logue and other comment efforts as part of the essential checks and balances in the standard-setting process.

As financial executives in pubhc companies, CCR members are charged with the responsibility of compihng, summarizing, analyzing and reporting large quantities of data to shareholders, the general public, regulatory agencies and operating manage- ment of the companies in which we work. We are also held accountable for fiscal respon- sibility, systems of controls and quality financial management processes that help pro- vide value for all investors and creditors.

The following are among the framework principles and other criteria that CCR takes into consideration when responding to inquiries about potential accounting stan- dards projects and assessing proposed accounting and reporting standards. 1) Standards should be based upon developed principles and concepts which

account for the true economics of a transaction. The financial statements should reflect the substance and significance of an entity's transactions in a standard, verifiable manner. Standards should be developed which re- quire transactions of similar substance to be accounted for consistently even though their form may vary.

Characteristics of High Quality Accounting Standards 189

The user community relies upon preparers to accurately refiect the eifect of all financial transactions in the financial statements and to utilize disclosures to com- municate information essential to understanding the financial statements. Rules should not be required which will cause confusion to the users of financial state- ments about appropriate measures of an entity's performance. While permitting some level of judgment, accounting rules should nonetheless be sufficiently defined to insure that substance rather them form dictates the appropriate accounting to be applied to a transaction.

2) A new standard should produce financial information which is more rel- evant and meaningful to users in evaluating an entity's performance than current standards or practices provide. The information required by a new standard should be concise, reliable and improve the quality of deci- sion-making effectiveness.

New accounting standards require a commitment of time and other resources by preparers as well as by users. Whether this investment is worthwhile is a func- tion of the extent to which decision making by users of financial statements is improved. Before proceeding with any new standard, there should be a clear un- derstanding of the way in which the new financial information will be used to improve the quality of decision making by users of financial statements. For ex- ample, FAS No. 106 on employee benefits has significantly improved the quality of financial decision making with respect to other post-employment benefits and has seemed to justify the high cost of its initial application. In contrast, it is unclear to many CCR members just how FAS No. 130, which deals with comprehensive in- come, will improve decision making.

Additionally, while still in the evaluation stage, careful consideration should be given to ensuring that the substance of the transaction is transparent to financial statement users. Transparency may require a change in accounting or, in some cases, disclosure alone will allow the users to understand the transaction. While we recognize that disclosure does not fix bad accounting, in some situations where the relevance and rehability of an accounting approach is not clear, disclosure may provide the user more complete information. For example, changing to a fair-value accounting model may not provide relevant results when financial statements are issued many months afber the valuation has been completed.

3) Effective accounting standards are those which have been founded on a direct exposure to, and study of, real-world operating conditions. Rigor- ous and objective evaluation of the perceived deficiency and an examina- tion of the relative effects of the deficiency, must be made prior to begin- ning a project.

Principal among the criteria we use to judge a proposed standard is whether we see evidence of a real need for change. When a new accounting and reporting project is on the horizon, our concern is to ascertain whether the project is worthy of the effort which will be needed to properly address the issue, undergo due process and see the project to completion. While a headhne news story of a major malfeasance may be an appropriate trigger for an inquiry, we do not believe that a single, or even a few instances of, breakdown within a larger system should be accepted, prima facie, as indicating a need for an accounting rule change. Instead, we believe that consideration should be given to the level and significance of these incidents relative to the opportunities for such an incident to occur.

190 Accounting Horizons/June 1998

We are skeptical of rule proposals that cite simply "a deficiency or an inconsis- tency in reporting" without discussing the actual harm or problem that results fi-om the deficiency. We all live in a world of complexity and ambiguity, so it is not persua- sive simply to cite an observation of a perceived deficiency. We want to know why it is a problem and why it is believed that a new accounting or reporting standard can correct it. Field tests should be considered before pursuing any new standards.

We know that change is costly, and that even analyzing and debating proposed change will consume significant resources. Our individual responsibilities, as fi- nancial officers of public companies make us very sensitive to cost/benefit issues. Our experience tells us that each perceived problem must be measured against the broad environment in which some occasional incidents or problems will occur, re- geirdless of the rules. Our initial approach of "reasoned skepticism" may seem nega- tive to others, however, we are trying to ensure that each new project represents a real issue of significance, warranting major activity on the part of all those involved in the process.

4) Before promulgation of a new standard, careful consideration should be given to determining that the proposed standard will prevent or minimize the perceived deficiency.

We are skeptical of rules promulgated in response to real or perceived "disas- ters," since our experience indicates that such actions may overcompensate for the original problem, create added ongoing costs for all parties without providing a commensurate benefit and, most importantly, not effectively address the core prob- lem. Often times, changes in accounting and reporting are proposed to address what in substance are control issues. Accounting and disclosure of derivatives is a case on point. Accounting and reporting standards are high quality if they fulfill a systemic qualitative or quantitative need rather than address internal control issues.

5) In a standard of high quality, a manageable subject is selected and bounded to permit completion of a new rule in a reasonable amount of time. The process for standard setting should be known, recognized and accepted by stakeholders.

Projects may become "too big to succeed." Our preference is to keep individual projects to a manageable size. Solving one specific problem is easier than rewriting a whole constitution. Projects should also meet periodic assessments of status vs. plan with the objective of avoiding "continuous projects." Projects should have an established time limit, such as one year, after which the project would be termi- nated if not re-justified.

6) A standard where benefits of implementation outweigh the real or eco- nomic cost to comply is considered to be of higher quality.

If a new standard better explains or captures the substance of a transaction or a series of transactions, a benefit has been obtained. However, if the cost to manipulate, analyze and report data associated with compUance is greater than the benefit de- rived, the stakeholder may actually lose "real" value in the form of reduced dividends, earnings and overall market value. Additionally, if a standard requires disclosure of confidential information, which management believes will cause competitive harm if disclosed, management may reconsider business decisions in order to avoid disclosxire requirements, tiius causing a potential economic loss.

7) A standard should be written to encompass the worldwide environment rather than be limited to situations which exist only in the United States.

Characteristics of High Quality Accounting Standards 191

High quality standards are developed with full consideration of approaches used in other mtgor countries and with an effort made to improve compa- rability, where possible.

One of the most vital issues facing financial reporting in the next five years is the globalization of capital markets and the acceptance of International Ac- counting Standards in the United States capital markets. Indeed, optimization of capital market efficiency requires the adoption of one set of worldwide ac- counting standards.

8) Standards should have a certain degree of flexibility. They should be a clear and concise statement of principles to be followed rather than a de- tailed list of provisions and ''bright lines."

It is difficult to envision that a single set of guidelines will be appropriate for all circumstances and transactions an enterprise may encounter. Therefore, it is para- moirnt that rules be focused on principles and intents so that appropriate account- ing and disclosure by each entity may best be left to management judgment.

9) Disclosures should be limited to key significant data, concisely presented. Disclosures should not provide numerous details which are not used to support

financial decision making by users of the financial statements. Disclosures should not be required simply because data is readily available, as to do so simply "clut- ters" financieil statements and may tend to obfuscate significeint data. Similarly, if data is gathered solely to meet external disclosure requirements, and is not used by management in its decision-making process, then its value to readers should be questioned.

10) A good accounting standard, has direct, clear and concise language which leaves no doubt as to what the standard is designed to address, what procedures and information are required, and why this additional information is required. There is significant value in "Plain English" communication.

A high quality standard is one that is readable and understandable by those who must implement the changes. Additionally, frequent use of examples and a question and answer section may help the reader better understand what informa- tion is being requested more so than many pages of written text.

11) Standards of high quality are those in which a follow-up procedure has been included or at least performed.

A standard's relevance is something which should be reviewed and considered even after the stsmdard has been issued. Sunset or review provisions should be placed in standards to allow the standard-setting body the ability to ensure the standard is addressing the perceived deficiency as planned.

In all our efforts, we have the goal of trying to ensure that chsmges proposed will be truly improvements, not just changes. We seek the highest and best use of our time and the time of all persons involved in accounting standard setting, as well as the time of those who manage or invest in our businesses and read our financial state- ments. Only in this way do we believe that true value and the best financial reporting can be created and maintained.