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Investors Should Pay Attention
To Accounting Reform Moves

By Art Berkowitz and Richard Rampell
November 21, 2002 .

Who ever thought accounting standards would get so much attention?

The corporate-accounting scandals of the past year have raised a number of issues for the accounting profession, not the least of which is what standards should we require corporations to use, and what governing body should set that standard.

Who does the dirty work and defines the rules is much more than a philosophical discussion or a political debate, and the answer may well determine if financial statements become more useful to investors.

Generally accepted accounting principles, also known as GAAP, are supposed to be "truth" in financial reporting. But who defines that truth? The answer to that question is critical to all of us.

People like to follow a leader, but right now, with two prominent individuals, Harvey Pitt and William Webster, stepping down from regulatory posts -- Mr. Pitt as chairman of the Securities and Exchange Commission, Mr. Webster as the head of the newly formed accounting oversight board -- the picture is unclear. Richard Shelby, the incoming chairman of the Senate Banking Committee, says that "in light of the scandals we have faced, the appointment of the new SEC chairman is more critical than ever. The bottom line is that accounting should be looking for the truth."

How do we get there, and is that a private or public initiative? Currently, there's a mix of the sectors regulating corporate disclosure, so we're really looking at altering the mix, rather than choosing a side.

The Financial Accounting Standards Board ( www.fasb.org 1 ) sets the rules in the U.S. The FASB rules are recognized as authoritative by the SEC ( www.sec.gov 2 ) and the American Institute of Certified Public Accountants ( www.aicpa.org 3 ).

But the FASB isn't the only group involved. The Emerging Issues Task Force, or EITF, the Accounting Standards Executive Committee, and the SEC itself all get into the act. EITF members are primarily the major public accounting firms and the AcSec is a product of the AICPA.

In a recent speech to Financial Executives International, FASB Chairman Robert Herz opined on whether the structure of accounting standards shouldn't be more closely controlled. "In looking at this whole issue, we believe that many of these concerns are valid and that the FASB as a primary accounting-standard setter needs to take responsibility for addressing this whole situation and, as needed, realigning the structure of U.S. standard setting," he said in a 33-page report to FEI 4 .

Some "rules" keep coming back to haunt regulators. Compromises reached years ago led directly to some of the recent hot-button accounting issues that have made headlines.

Nearly 10 years ago, the FASB proposed that stock options be expensed. Corporations objected strongly, and FASB statement No. 123 5 was born, which set the current loose standards for disclosure of stock-based compensation plans. Not surprisingly, that issue is back in the news now.

Similarly, the accounting rules for materiality are a good example. The SEC altered its rules to include qualitative as well as quantitative measurements of materiality when no other regulatory body was considering changes, and if Arthur Andersen had used those rules properly, a major issue in the Enron scandal could have been avoided.

Were it not for the SEC using its authority to issue accounting standards, we wouldn't have had the positive changes that were implemented in recent years. On the flipside is the so-called 3% rule for special-purpose entities that was at the center of the Enron scandal.

That guideline allows a special-purpose entity to be taken "off the books" so long as 3% of its capitalization comes from outside the parent company. The rule is currently under review, with some proposals raising that threshold to 10%. (For an explanation, see " Special-Purpose Entities Are Often a Clever Way to Raise Debt Levels 6 ," Feb. 21, 2002.)

Further complicating matters, the recently enacted Sarbanes-Oxley Act has given the new Public Oversight Board the authority to issue standards. How widely the new overseers exercise that power will influence the future direction of accounting standards.

One important part of the debate will be whether financial information moves more toward using market value rather than historical cost as the basis for financial-statement disclosures. The proponents of market value (a k a fair-value accounting) believe that current standards provide less relevant financial information to users who are trying to make investment decisions.

The problem, as illustrated so clearly by Enron and other recent scandals, is that there is a trade-off between the reliability of the information and its relevance. Fair-value accounting allows for greater manipulation of financial statements to meet specific goals. For example, a company may have a lot of real estate holdings on its books, which are recorded at original cost, less depreciation. The fair-market value may be much more than the book value, and a compliant appraiser may exaggerate the real value.

In addition, there has been a significant movement to converge U.S. accounting standards with those of the International Accounting Standards Board ( www.iasc.org.uk/cmt/0001.asp 7 ). Some critics have complained that European standards aren't comparable to (translation: "as good as") U.S. standards and we shouldn't be changing our standards to fit the rest of the world. Interestingly, the supporters of convergence include most of the top accounting organizations, the major accounting firms, and the AICPA.

So where are we headed with accounting reform and standards settings?

In the short run, there are two conflicting schools of thought. One believes that the Republican sweep in the midterm elections will ease the pressure to reform. The other assumes that the scope of corporate scandal will lead the public to demand more transparency. We find neither convincing.

While economic policy and the argument for private vs. governmental control may be political, history has shown that it isn't partisan. Some of the leading supporters of the status quo have been members of the Democratic Party and many leaders of the accounting-reform movement are Republicans. History also shows us that the public often has a very short memory and may lack the stamina to follow through on significant reforms.

Sheryl Thompson, an FASB spokesperson, argues fervently that the standard-setting process must be handled by people with an accounting background. While that may be true, the needs and input of investors is critical, and the FASB has taken an important step by inviting comment about a proposed change to stock-option accounting.

In an effort to spur participation, the FASB's Mr. Herz wrote a letter to the CEOs of the 25 largest mutual-fund groups, the major investment and commercial banks, rating agencies, and other investor groups soliciting names for an advisory council. Individual investors should get involved, too, by writing to the FASB, or their congressional representatives.

It's only the involvement of individual investors and consumers that can prevent regulatory agencies from being "captured" by the industries they oversee -- virtually no one other than accountants testifies in state legislatures or regulatory bodies on accounting rules or legislation, for example. That must change if transparency is to be increased.

And it's critical for individual investors that transparency be increased, and that shareholders no longer need to rely on the financial-news media to spotlight economic catastrophes such as Enron lurking in the market. True reform can happen, but only if the accounting industry hears opinions from all sides.



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