A man of principles

FASB chairman Bob Herz suspects corporate abuse would be greatly reduced if companies had to comply with the spirit, not just the letter, of accounting law. So he’s pushing a “principles-based” system to replace the current rules-based regime -- making some CEOs nervous.

“Our clients are saying that auditors are getting more and more unreasonable,” reports Fred Tepperman, founder of Old Westbury, New Yorkbased investment boutique FLT Investors. A senior technical partner at Arthur Young & Co. in the 1970s and CFO of Warner Communications from 1981 to 1983, Tepperman recalls that back when he was wearing a green eyeshade, the whole of accounting regulation could be bound into one barely inch-thick book. “Now it takes entire bookcases to hold it all,” he laments. “It’s just not manageable.”

Robert Herz, chairman of the Financial Accounting Standards Board, which spawned most of those rules, would be inclined to agree with Tepperman. In a gutsy all-out assault on accounting’s established credo, Herz wants to move from a strictly rules-based regime to a “principles"-based one to undo much of the bewildering specificity of U.S. accounting standards and bring U.S. companies more into line with European and Asian ones.

The Securities and Exchange Commission, which enforces the rules that FASB writes, endorses this effort. “We need to get back to principles-based accounting -- using judgment where required and relying less on excessively complex rules,” contends Donald Nicolaisen, the former PricewaterhouseCoopers senior partner who is the SEC’s chief accountant. “There are different ways to accomplish this, but FASB knows best how to write accounting standards, and it’s up to it to determine the best way to do this.”

As logical as converting to principles-based accounting might sound, the FASB chairman has an alley fight on his hands. The principles-versus-rules distinction may, like so many others in accounting, sound obscure to laymen, but it would have momentous consequences for companies. Just for a start, the current surfeit of specifics, however exasperating, has one great virtue: If an American CFO or CEO punctiliously adheres to them, he or she probably won’t be perp-walked off to jail.

“In the environment we live in, lawyers are waiting for the opportunity of a company making a mistake or experiencing a negative event,” points out John Sheehan, controller and chief accounting officer of Troy, Michiganbased auto-parts maker Delphi Corp. “It drives a mentality where companies require a rules-based system to protect themselves.”

A principles-based accounting system, on the other hand, presents a less-concrete categorical imperative. Broadly speaking, it commands companies to “do the right thing.” As an October 2002 FASB study put it, a principles-based approach “would increase the need to apply professional judgment consistent with the intent and spirit of the standards.” Says Tepperman with a shrug: “There is no perfect answer, but the emphasis on principles is a better one. It requires clients and auditors to reflect on what they’re doing.”

Herz’s principles-based approach also promises an even greater payoff: an eventual convergence between the U.S.'s generally accepted accounting principles and international financial reporting standards, which European companies are required to use beginning this year. By converging U.S. GAAP and IFRS around commonly agreed-to principles, U.S. and European regulators hope to make it easier for investors to compare financial results and for companies to access capital markets around the world.

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As the senior technical officer in PricewaterhouseCoopers’ national office, Herz gave thumbs up or down on clients’ accounting practices. Today, he says, the problem of the U.S.'s overly rule-bound bookkeeping system has become urgent. “The proliferation of rules and exceptions to rules and rules about the exceptions have made it increasingly hard even for good guys to comply,” he asserts. “Rules have not only increased compliance risk, they have also provided opportunities to structure transactions to achieve desired accounting outcomes.”

CONSIDER HOW THE RULES-VERSUS-PRINCIPLES debate plays out with respect to that timely and always contentious accounting issue: the expensing of stock options awarded to executives and employees. On December 11, FASB’s seven members unanimously voted, as expected, to force companies to start deducting the value of employee stock options from their profits beginning in mid-2005. That caused a reflexive uproar, particularly among technology companies, which contend that forcing them to treat employee stock options like any other form of compensation crimps their entrepreneurial style.

“I’m concerned that we’re going to see a domino effect if expensing options becomes prohibitively expensive,” Dennis Powell, CFO of Cisco Systems, told Institutional Investor right after FASB’s decision. “It will have the impact of stifling innovation and technology development in this company.” Gerard Langeler, a general partner at OVP Venture Partners in Kirkland, Washington, is no less emphatic: “We think it’s bad, pure and simple. The thing that entrepreneurial companies have to offer is stock. What they don’t have to offer is cash, which is exceptionally dear. The Chinese government made it clear that they support stock options -- and here we are trying to do away with them.”

Jeffrey Peck, a well-known tech company lobbyist, notes that “the Congress for this session is done, so we’ll be back at it in the 109th Congress.” He judges the prospects for thwarting FASB on option expensing to be “quite good.”

For Herz, however, the case for treating options straightforwardly as an expense rather than burying them in footnotes to financial statements is self-evident and flows from one of the most basic accounting principles: Expenses should be recognized and matched against the revenues that they help generate. Proponents of expensing options point out that to employees, stock options in fact represent compensation, however difficult they may be to quantify; therefore, they say, options constitute an expense incurred to produce revenue and should be reflected in the profit and loss statement. Says Herz, “The accounting for options is a clear problem in financial reporting, and if we don’t fix it, we’re not improving the system.”

The system, however, is resisting repair. FASB had to postpone implementation of its FAS 123(R) standard on expensing options from this month to June because of prodding by the SEC, which felt that companies needed more time to digest the welter of changes mandated by the landmark Sarbanes-Oxley Act of 2002. The securities agency, however, was itself under intense pressure from business lobbyists and some members of Congress to hold off on FAS 123(R). (SEC chairman William Donaldson, meanwhile, has become the target of pro-business forces who say he has been too zealous in enforcing securities laws.) The delay in imposing FAS 123(R), of course, gives opponents more time to mount organized resistance. If critics succeed in scuttling FAS 123(R) in the next six months -- they’ve kept it at bay for a decade now -- then Herz’s wider campaign to promote a principles-based accounting regime will no doubt suffer a major setback as well.

The FASB chairman is well aware of the stakes. Confiding that he “certainly hopes” Congress won’t block FAS 123(R), he warns that doing so “could raise some legitimate questions about the integrity of the reporting system, such as, Who are financial reports prepared for, and why? Are they prepared to properly inform investors and other users, or are they prepared to enable companies to cast themselves in a favorable light?” (For more on the stock option brouhaha, see box, page 26.)

The FASB chairman knows full well how daunting his mission is. Employing the kind of candor he would like to see more of in financial statements, he concedes that “we’re having real challenges moving away from detailed rules and bright lines.” (Bright lines are the highly specific thresholds that often determine how to account for an action: If the present value of future lease payments represents at least 95 percent of the value of an asset, for instance, that lease must be capitalized.)

Nevertheless, Herz, who is probably the most activist FASB chairman in the board’s three-decade history, will be aided in his reform effort by propitious timing. Appointed on July 1, 2002, just as WorldCom’s massive accounting fraud was unfolding, he is the first FASB chief to be named since the passage of Sarbanes-Oxley.

“He’s in a very good position to get things done,” says Dennis Beresford, who was FASB chairman from 1987 to 1997 and is now an accounting professor at the University of Georgia and a director of MCI, the former WorldCom. Beresford backs the idea of principles-based accounting, noting that “the point of financial reporting is to have managers present their best estimates of what has happened and what will happen.”

In Herz’s two and a half years in charge of the FASB board -- long notorious for its glacial deliberations -- he has expeditiously pumped out new standards and interpretations incorporating the principles-based viewpoint on such issues as off-balance-sheet financing (FIN 46[R]), financial guarantees (FIN 45), liability-equity classifications (FAS 150), pension liability disclosure (FAS 132[R]) and stock option compensation (FAS 123[R]).

In each case, FASB pointedly spelled out how the new standards or the changes to existing ones relate to the basic principles of financial reporting embodied in the organization’s conceptual framework -- such principles as the completeness of disclosures and the relevance of information.

“Since Herz took over, FASB has been moving a lot faster,” says Colleen Sayther Cunningham, president of Financial Executives International, an association of CFOs. She adds with a sigh, “I’d maybe like to see them slow down a little bit.”

The enormity of Herz’s task allows him scant time to pause. His challenge in trying to implement simpler, principles-based standards is frustratingly evident in the tale of special-purpose entities. When Accounting Research Bulletin No. 51, Consolidated Financial Statements, was promulgated in 1959, it was perfectly clear: As long as an independent third party contributed at least 3 percent of the total capital of what is now called a special-purpose entity and exercised nominal voting control over it, the company that sponsored the SPE didn’t have to put the entity on its balance sheet. After all, the reasoning went, a third party with a not-insignificant stake in an SPE would make sure the company didn’t manipulate the entity solely for its own benefit.

But then the clever CFO of a certain energy company came up with a creative twist on this notion. He gave guarantees to third-party investors in his company’s SPEs. In that way, Enron Corp.'s Andrew Fastow was able to transfer all sorts of suspect assets with wildly inflated prices into a warren of off-balance-sheet SPEs, in nominal compliance with accounting rules and with the blessing of Enron’s auditor, Arthur Andersen. Enron’s balance sheet gave no hint of the enormous risk it was shouldering with SPEs. Investors and employees, however, discovered that soon enough.

So did chagrined regulators. In light of the explosive growth of SPEs and the potential for more Enron-style disasters, FASB addressed the problem by issuing Financial Interpretation 46 in January 2003, followed by a revised version 11 months later. The regulation -- widely seen as FASB’s most clearly principles-based standard since Herz took charge -- increased the 3 percent threshold to 10 percent. More important, it put the onus squarely on corporate managers to determine whether an entity could be kept off the balance sheet or ought to be consolidated, based on the economics of the situation and regardless of the size of any third-party investment.

But that, unhappily, wasn’t the end of it. “The new SPE rule had a good set of principles,” says Herz wearily. “But people came up with thousands of questions.” Naturally, FASB felt duty-bound to answer those questions within the standard itself. On the way to approval, FIN 46 morphed into a 75-page document with copious instructions on how to determine expected losses and returns, among other matters.

“FASB thinks the new SPE rule is a principle-based standard, but it’s still extremely complicated,” says Baruch College professor Norman Strauss, a respected analyst of accounting practices. The SEC’s Nicolaisen defends FASB. “FIN 46 was developed in a hurry at our insistence,” he points out. “In the post-Enron environment, companies wanted to make sure they were doing things right. I wouldn’t judge principles-based accounting by this standard.”

BESPECTACLED AND BALDING, HERZ, 50, MAY look like a central casting version of a mild accountant, but he is a surprisingly forceful advocate for his profession and for reform. Born in Maplewood, New Jersey, Herz moved to Buenos Aires at 15 when his father, an American commodities trader, took a job with agribusiness giant Bunge. After three years in an Anglo-Argentinean bilingual school -- “I remember dreaming in Spanish,” says Herz -- he moved to England and enrolled at the University of Manchester, earning a BA in economics in 1974. Price Waterhouse offered him a job, and he spent the next four years working out of the firm’s London and Manchester offices while pursuing his chartered accountant’s degree. In London he met his English-born wife, Louise, who has become a U.S. citizen.

“I convinced my bride that the big money was back in the U.S.,” confides Herz, whose salary in England topped out at £800 ($1,524). He returned stateside in 1978 and joined Coopers & Lybrand in Boston. Like other audit firms at the time, Coopers was in the early stages of expanding into lucrative nonaudit services such as tax planning, business valuation and technology consulting. By the late 1980s, Herz was heading the firm’s corporate finance practice, but he wasn’t happy as a consultant. “It got too product- and fee-oriented, and conflicts of interest developed,” he says. “When the economy took off, it got out of hand.”

All along, he had shown a predilection for the technical side of accounting. After Herz received a gold medal on his U.S. CPA exam in 1979, Coopers made him a FASB project manager, responsible for staying on top of the board’s deliberations and pronouncements. “He’s one of the smar-test guys I know,” says Raymond Beier, lead partner in PricewaterhouseCoopers’ transactions services group. By the mid-1990s, Herz was back in his element as Coopers’ top New York technical partner, interpreting accounting arcana for audit clients and other partners. He kept that role when Price Waterhouse and Coopers combined in 1998.

Although Herz is an avid fan of New York sports teams the Yankees, the Giants and the Knicks, he has a fondness for things British, including football, cricket and, as it turns out, British-style accounting. “Accounting is probably the leading profession in England,” he observes. “There are obviously some structural differences between us -- like the legal systems -- but I’d like to see us emulate theirs.”

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The key difference between the British and American systems, he points out, is the use of judgment by corporate executives and auditors. The rules issued by the U.K.'s Accounting Standards Board tend to be far less detailed and prescriptive -- in keeping with the principles template -- than those produced by FASB. Furthermore, issues usually get resolved in a collegial fashion.

“In England you could get all the people that mattered in a situation into one room to work it out,” says Herz. U.S. corporate accounting policies, by contrast, are typically determined by lawyers and technicians being legalistic and technical. The FASB chairman calls it “a game of how to paint pictures.”

Herz recognizes that lawyers’ and accountants’ esoteric interpretations can cause accounting to become detached from reality. He “understands the convergence of finance and accounting,” says PWC’s Beier. That grasp of accounting in a real-world context -- something that not all FASB chairmen have exhibited -- underlies Herz’s far-ranging agenda.

He seeks to change the fundamental mind-set of companies and accounting firms to wean them from strict reliance on rules-based reporting and win them over to principles-based reporting. Herz also aims to simplify guidelines for measuring the fair value or the market value (where market prices pertain) of assets and liabilities -- another charged topic. FASB came forth with a fair-value proposal in June, and although the document does not say when or where to apply market prices, it could conceivably serve as a platform for extending fair-value accounting to a broad swath of financial transactions (see box, page 28).

Herz is also consolidating under FASB the authority to issue accounting edicts. Everyone from the American Institute of Certified Public Accountants (which served as FASB’s predecessor) to FASB’s own emerging-issues task force to the SEC to specific industry regulators have chimed in on accounting standards over the past two decades. “We’re trying to stop the proliferation of standards coming from different sources,” declares Herz. To that end, FASB has relieved the AICPA of its standard-setting duties and it now requires that all EITF pronouncements receive explicit board approval. And the FASB chairman has assigned a high priority to promoting the convergence of U.S. GAAP and international financial reporting standards to reduce the disparity between the two accounting regimes.

Taken together, Herz’s initiatives would represent the most radical overhaul of financial reporting in decades. But if ever FASB were going to be audacious, now is the time. Corporate scandals have created a clamor for reform. Although Enron, WorldCom and other financial reporting outrages were first and foremost cases of crooks being crooked, Herz and many others consider accounting rules to be partly to blame.

Herz’s reform efforts are being matched by EU regulators and the London-based International Accounting Standards Board, which is developing IFRS from a principles-based approach but writing lots of rules to guide firms in interpreting the more complex issues (Institutional Investor, July 2002).

In November the European Commission, which has mandated that EU companies adopt IFRS this year as part of its effort to strengthen Europe’s single market, agreed to require companies to apply IAS 39. A virtual copy of the U.S.'s FAS 133, it requires derivatives and other financial instruments to be valued at market prices (although the commission did permit some temporary exceptions that throw IAS 39 somewhat out of alignment with FAS 133). And just this month the commission agreed to adopt IFRS 2, which mandates that companies expense stock options. (The commission has the last word on whether, and when, companies within the EU must abide by IASB standards.)

“It’s encouraging to see they’re now both moving in the same direction,” says Mark Vaessen, head of the international financial reporting group at KPMG in London, referring to U.S. and European accounting bodies. Stock options and fair-value accounting “are level-playing-field issues,” he adds.

U.S. GAAP, THE WORLD’S MOST EXHAUSTIVE BODY of accounting rules and guidelines, is overburdened with detail, riddled with exceptions and bound up in bright lines, all of which make it vulnerable to manipulation, say its legion of critics. GAAP, they contend, enabled executives and auditors to structure transactions that ostensibly conformed to accounting rules but violated basic tenets of transparency and fairness.

“The bright lines get into our standards because of politics and because preparers want them there,” says Rebecca McEnally, senior director of capital markets policy for the CFA Institute, a global association of securities analysts based in Charlottesville, Virginia. “So long as we have those bright lines, there is the possibility of gaming the system.”

Congress recognizes the danger. In Sarbanes-Oxley legislators commissioned the SEC to examine the feasibility of adopting a principles-based system in the U.S. The resulting study, completed in July 2003, gave four examples of areas in accounting literature that were “located toward the overly specific end of the spectrum": derivatives and hedging, stock-based compensation, recognition of financial assets and liabilities (as with special-purpose entities) and leases.

Consider the guidance just for lease accounting: It is dispersed across 16 FASB statements and interpretations, nine technical bulletins and 30 pronouncements of FASB’s emerging-issues task force. Herz calls the lease literature “cookbookish.”

Most businesspeople would concede that accounting has become too rules-fixated. Nonetheless, like Delphi’s Sheehan, they fear that the extra level of judgment required of them in a principles-based system would make them vulnerable to being second-guessed -- not least by plaintiffs’ attorneys -- if their assumptions turned out to be wrong. “In concept, principles are the right way to go,” allows Financial Executives International’s Cunningham. “But with our litigious society, it will be very difficult to do without tort reform.”

Joseph McCoy, controller and chief accounting officer of energy producer Burlington Resources, puts it plainly: “It’s critical that the regulators make their principles clear enough that companies and auditors have sufficient guidance to support their judgments.”

Paradoxically, Sarbanes-Oxley may impede the shift to an accounting model built around principles. The law requires CEOs and CFOs to certify the accuracy of their companies’ financial statements and stiffens the penalties for shoddy financial reporting. Accordingly, executives will be loath to cast off the security blanket of specific rules.

Herz’s chore is to change a corporate culture that stubbornly views financial reporting as an exercise in check-the-box compliance. Just three months after his appointment, FASB issued a bold manifesto: “A Principles-Based Approach to U.S. Standard Setting.” In the 11-page proposal (and its 11-page appendix), Herz and his fellow board members advocated greater reliance on the basic principles of financial reporting set forth in FASB’s core-concept statement and less recourse to specific guidance. FASB board member Edward Trott, a former KPMG partner who served with Herz on the board’s emerging-issues task force in the early 1990s, acknowledges that “both FASB and the EITF had gotten to the point where they were providing too much guidance and including too many bright lines describing how to treat things.”

The SEC’s Nicolaisen, putting first things first like a good accountant, suggests that before FASB gets too deeply into principles-based accounting, “it is extremely important that it review and update its conceptual framework.” This entails addressing shortcomings and inconsistencies in the seven financial accounting concept statements issued by FASB between 1978 and 2000 that set out the objectives of financial reporting, the proper characteristics of accounting information, the elements of financial statements and the acceptable procedures for financial measurement. This fundamental framework is rickety in parts, particularly in dealing with the trade-off between the relevance and the reliability of information and in defining differences between the basic elements of financial statements, such as liabilities and equities.

With Herz’s hardy blessing, FASB officials are well into a project to rationalize the organization’s conceptual framework. The ultimate aim: to develop a common framework with IASB.

That should help with the adoption of a more-principled accounting order. The trick, though, is making the transition. The U.K. found that for a principles-based order to succeed, it needed what is called a “true and fair override": In the rare cases where strict compliance with the rules of Britain’s Accounting Standards Board fails to result in a true and fair picture of a company’s financial position, corporate officers and their auditors are obligated to break the rules -- and are protected if they do so for a legitimate reason.

The 2003 SEC study concluded that no such formal shield was necessary in U.S. principles-based accounting because “the standards should be based on objectives that would almost certainly not be met by a presentation that was not true and fair.” Amplifies Nicolaisen: “The principles themselves are sufficient. Companies shouldn’t have to reach out for a different accounting view altogether. If they feel that some non-GAAP numbers are needed to better understand their financial picture, then they should be in the management discussion and analysis section.” The issue may be more one of semantics than of standards. Robert Willens, an accounting analyst for Lehman Brothers, suggests that “we’re going in the direction of true and fair override without calling it that.”

Still, convincing corporate officers to use their good judgment to report their companies’ accounts in a fair and accurate manner -- rules be damned -- will take some doing. “People are resistant to change,” acknowledges Herz. “They are saying, ‘I know the principles, but give me a rule.’ It’s a behavioral thing that has evolved.”

“Evolution” may be the operative term here. Herz and FASB are using persuasion, not a cattle prod, to try to change executives’ and accountants’ behavior. “This is a philosophical discussion about where our financial reporting system is going” says Burlington Resources’ McCoy of the principles push. Adds PricewaterhouseCoopers’ Beier: “There are no definitions for principle-based and rule-based standards. ‘Principle’ is a code word for avoiding overly detailed standards.”

Herz wouldn’t necessarily dispute that assertion. As he sees it, the principles-rules debate is not an either-or situation. “The SEC study got this right,” he says. “We need to articulate clear principles with fewer exceptions and bright lines and support them with good implementation guidance.”

A number of major FASB actions have sought to weed out exceptions and make existing standards more straightforward. For example, FAS 141, Business Combinations, issued in September 2000, did away with the pooling-of-interests method of accounting for acquisitions. For years companies had performed contortions to satisfy the 12 conditions needed to qualify a merger as a pooling rather than a purchase transaction. They could thereby avoid creating goodwill that would have to be amortized over time as charges against future earnings.

The hitch is that corporate accounting managers now must undertake the torturous task of determining the fair value of businesses they acquire and the goodwill generated by mergers. And they now have to periodically assess whether competition or market circumstances have hurt the businesses and detracted from the goodwill. If so, the value of these impairments must be charged against earnings. Say this for FAS 141: It has provided investors with more information to evaluate acquisitions.

HERZ’S COMMITMENT TO PRINCIPLES-BASED financial reporting dovetails nicely with his desire to bring about the convergence of U.S. GAAP and IFRS. Herz, who served part-time on IASB for 18 months before joining FASB, met with IASB chairman Sir David Tweedie soon after taking office. The two boards subsequently convened at FASB’s Norwalk, Connecticut, headquarters. The resulting memorandum, dubbed the Norwalk Agreement, pledged IASB and FASB to eliminate differences between their standards and to pursue new ones together. Current joint projects include deliberations on business combinations, financial performance measurement, stock-based compensation and revenue recognition.

IASB’s vice chairman, Thomas Jones, a former chief accountant for Citicorp, regards Herz as a true believer in the value of global accounting standards. “He’s an internationalist at heart,” says Jones.

But although the goal of cooperation is a laudable one, business communities around the world have quite different agendas. If Congress winds up quashing the expensing of stock options, for example, it would put FASB out of sync with IASB.

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For convergence to succeed, “a lot depends on the capacity of the accounting professions and the companies that prepare financial statements in different countries to handle the change,” points out Peter Wong, former president of the Hong Kong Institute of Certified Public Accountants and author of a study on convergence for the International Federation of Accountants. Countries signing on to the international accounting standards will figure out road maps to get there over the next several years, he says, but he warns that differences in language, business culture and legal systems throw up major obstacles.

Precisely which standards FASB and the IASB should converge toward is itself in dispute. Some U.S. accounting observers insist that IASB standards give companies too much latitude. “I like our approach better because the results produced are more comparable,” says Charles Mulford, a well-regarded accounting professor at the Georgia Institute of Technology.

For Herz, however, the two approaches are not at odds. “We’re trying to write simpler, more principle-based standards,” he explains, “and IASB is writing more-detailed, lengthy standards. They’re getting longer, and we’re getting shorter.”

Is there some happy global medium? IASB’s Jones is just as adamant as Herz that a rigidly rules-based regime is ultimately self-defeating. “FASB has been forced into the position of anticipating and answering questions and issuing hundreds of interpretations -- it’s a path to doom,” he says. “Standards can’t cover every issue, and the more detail you put into them, the more problems that can arise.”

All the same, peddling a principles-based system to U.S. CFOs and accounting partners is no Sunday picnic. One member of FASB’s user advisory group, a forum of 40 analysts, investors and others who rely on financial statements that meets periodically with the board, is scathing about the whole exercise: “The principles-based initiative is a red herring. If FASB had any courage, they would have stopped carving out exceptions to rules when big companies demanded them a long time ago. FASB just isn’t strong enough to make this kind of change.”

Delphi’s Sheehan is only a bit more optimistic. “We won’t go from one extreme to the other,” he predicts wryly. “It took 20 to 30 years for standards to become as detailed as they are, and it will probably take 20 years to go back the other way.”

The SEC’s Nicolaisen grants that “momentum is always hard to change.” His prediction: “We won’t see an overnight switch to a new [principles-based] model. It will be an evolutionary change.”

As is not always the case in accounting matters, an accountant gets the last word here. “There are a lot of challenges to a principles-based system,” Herz concedes. “We’re in a period of crosscurrents, and people are learning to deal with a new environment. Now companies are saying, ‘Just give me the answer.’ But this, too, will pass. People have to be able to see that good, fair judgments are respected.”