A Standard Setting Perspective on Current Issues Facing the Accounting Profession

1. A Standard Setting Perspective on Current Issues Facing the Accounting Profession Accounting Programs Leadership Group February 2004 Katherine Schipper Financial Accounting Standards Board The views expressed in this presentation are my own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

2. Overview • An aside on FASB process changes • Three categories of issues facing the accounting profession • Convergence with international standards will affect US GAAP • Short term convergence projects • Long term alignment of agendas • Increasing complexity and variety of business models • Difficulties in defining the boundaries of the reporting entity • Increasing reliance on fair value measurements • Financial reporting failures and the legislative/regulatory responses

3. Process changes at the FASB • FASB staff positions (FSPs) • Replace FASB staff announcements and Q&A documents • Posted on FASB website for (usually) 30 day exposure period. After clearance, posted as GAAP on the website. • Will be included in Current Text • Standards available free in pdf format from the FASB’s website: www.fasb.org • Sign up for a free e-mail version of Action Alert to be notified of FASB activities • Summaries of decisions at most recent meeting • Topics to be discussed at next meeting • Posting of FSPs

4. International convergence • Convergence as a concept has few detractors • Detractors point to jurisdiction-specific circumstances that should be accommodated • Empirical question: what (if any) jurisdiction-specific circumstances are sufficient to require jurisdiction-specific financial reporting standards? • Should the same (or similar) transactions be accounted for differently, depending on where they occur? • Differing legal systems • Differing organizational/ownership structures

5. International convergence • Convergence as a process is yet to be fully specified • Added sense of urgency => 2005 requirement that listed firms in European Union jurisdictions must use international standards (IFRS) for consolidated reports • US GAAP users in the European Union must use IFRS as of 2007 • Recent evidence of political intervention • Current focus: financial instruments, derivatives and hedging • Under what circumstances will the SEC permit non-US registrants to use IFRS without reconciliation?

6. International convergence—FASB actions • New standards • Joint projects with IASB • Business combinations: purchase procedures • Revenue recognition • Monitor IASB projects • Performance reporting • Goal is to develop the same standard and (eventually) converge agendas • Intent is to add no new differences between U.S. GAAP and IFRS • Existing differences • Hundreds of existing differences, even in revised IRFS • Derivatives • Liabilities and equity

7. International convergence—FASB actions • “Short term” convergence projects • Choose between existing IASB and FASB standards • Presumption => more recent standard is likely to be superior • Examples of current short term projects • Nonmonetary exchanges => more gain recognition • Accounting changes => more retrospective applications • Liability classification => different criteria for classification as current obligations • Examples of short term projects to be taken up next • Income taxes • Research and development • Interim reporting • Will this project achieve “substantial convergence” by 2005? • Most frequently occurring differences? • Largest items in magnitude?

8. International convergence—FASB actions • How will this project affect U.S. GAAP? • Convergence => changes to U.S. reporting requirements in the absence of identified problems • Tangible and immediate costs to preparers, auditors and users • Accounting education: numerous, frequent and possibly significant changes to textbooks and teaching materials • Changes are undertaken to achieve longer term benefits

9. Increasing complexity and variety of business models • Issues for financial reporting • Defining the boundaries of the reporting entity • Joint ventures • Affiliates • Specially designed structures used for a variety of commercial arrangements • When should these arrangements be consolidated with the reporting entity? • Financial reporting as the allocation of transaction amounts versus direct measurements • Revenue recognition in multiple element commercial arrangements • Derivatives: nominal or no transaction amounts • Traded versus non-traded instruments • Both financial reporting and auditing considerations

10. Defining the boundaries of the reporting entity: consolidation • Purpose of consolidated financial statements • Report financial position, results of operations and cash flows as if all the assets, liabilities and activities were held, incurred and conducted by a single entity with several branches or divisions (adapted from ARB 51) • Based on the concept of completeness => presenting all assets, liabilities and activities that are under control of a single management and governing board • Conclusion: consolidate an entity when it is controlled by another entity • Problem: control is not well defined in financial reporting.

11. Defining the boundaries of the reporting entity: consolidation • Defining control • Approach 1: Identify instruments that convey control and apply quantitative analysis to determine if a party has enough of the instruments to achieve control • Approach 2: Apply professional judgment to facts and circumstances, given a qualitative definition of control • Example (from a 1999 FASB Exposure Draft): Control is the (unshared) ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities.

12. Defining the reporting entity: consolidation Quantitative approaches to defining control • Accounting Research Bulletin 51 (and most practice) refers to a controlling financial interestas the basis for consolidation • Convention => equity shares are the instruments that convey control, via voting • Control => use voting power to elect the governing board and to make other significant decisions • Analyze controlling financial interest by analyzing equity voting interests • Holder of majority of equity interest => control • Count the total number of votes. A holder that has more than half of the votes has a controlling financial interest and should consolidate

13. Defining the reporting entity: consolidation • Quantitative approaches to defining control • Problems arise when control exists or can exist without a majority equity voting interest • Latent control: holder of an instrument (e.g., a convertible debenture or an option to purchase shares) that can be converted to a majority voting interest or exercised to obtain a majority voting interest • Straw man: holder of a substantial minority interest has an arrangement with a related party who holds sufficient shares to give the holder a majority interest

14. Defining the reporting entity: consolidation • Quantitative approaches to defining control • Problems arise when control exists or can exist without a majority equity voting interest • Effective control: holder of a substantial minority interest and no other holder (or organized group) has a significant interest. • Example: Pyramid arrangements and cross-holdings • Example: Coca Cola holds substantial minority interests in some of its bottling affiliates. Does Coca Cola control those affiliates? • Question: Should patterns of voting behavior affect whether one entity controls another entity? • Question: Perhaps the holder of the substantial minority interest is currently in control, and the issue is whether he can perpetuate control. • Voting (equity) interest does not convey control, because of the design of the entity

15. Voting interest does not convey control Lenders to Entity Guarantee (?) Operating Co. A Owners (?) Entity designed to achieve a special purpose Business arrangements Observations: Operating Co. A does not own the Entity The Entity’s business arrangements are with Operating Co. A Typically, the Entity is highly leveraged. Co. A (or another entity) may guarantee the loan from lenders to Entity. SPE (Special Purpose Entity) is used to describe a wide variety of structures. However, there is no agreed-on definition of “SPE.”

16. Voting interest does not convey control • Structures like the Entity are used for many commercial purposes • Securitizing assets • Entity receives assets from one or more Transferors and issues debt to investors • Leasing • Entity holds the leased asset. An operating entity leases the asset and may provide a residual value guarantee. • Performing research and development or start-up activities • While financial services firms use these structures extensively, they are also used by other firms • Examples: Ford, Kimberly-Clark, Boeing, Lucent

17. Assessing control when voting interest does not convey control • Question: Under what circumstances is it not appropriate to assess controlling financial interest by analyzing voting (equity) interests? • Question: Under what circumstances would Operating Co. A have a controlling financial interest in Entity, even though A does not own any of Entity’s equity? • Interpretation 46R provides guidance for answering these questions • Suggests qualitative assessments but • Provides for quantitative analysis to determine who (if anyone) should consolidate the entity

18. Difficulties in applying the concept of control to defining the reporting entity • Qualitative judgment • Difficulties with verifiability (different preparers reach different conclusions for a given fact pattern) • Outcomes may not be comparable • Quantitative analysis based on majority voting interest • Control may exist without majority ownership of voting interests, even if voting interests can convey control • Some entities are designed so that voting interests cannot convey control • Identify instruments and contractual arrangements that convey control • Create measures of those instruments that can be analyzed arithmetically

19. Fair value measures Definition: amount at which an asset could be exchanged or a liability settled in a current hypothetical transaction between knowledgeable unrelated willing parties • Key attributes: • Hypothetical transaction => no requirement that a market exist • Current transaction => measure is not intended to capture the most likely settlement amount • Example: An arrangement will settle for 100 with probability .30 and for 0 with probability .70. The most likely settlement amount is 0. A current transaction would reflect the dispersion of outcomes: .30 x 100 + .70 x 0 => 30.

20. Fair value measures • In some cases fair values can be ascertained from observed prices in active markets • Increasing use of fair value estimates in financial reports • Examples • Asset retirement obligations (except for historical discount rate) • Acquired assets and liabilities in a business combination • Impaired assets (inventory, fixed assets, goodwill) • (Disclosed) fair values of some financial instruments • Guarantees (unless a specific premium is received) • Derivatives (unless traded in active market)

21. Fair value measures • Intent is to increase the relevance of reported numbers • Only measurement attribute for certain derivatives • Example: Interest rate swap • Most relevant attribute for (many) incomplete transactions • Alternative is allocations of transaction amounts • Examples: EITF 00-21 (revenue recognition); SFAS 140 (retained interests in securitizations) • These allocations require their own estimations (which may be based on fair values) and so are not free of estimation error • Key issues • What is the actual reliability of fair value measures? • How reliable are fair value measures compared to the reliability of other reported numbers that are based on estimates and judgments? • What are the auditing considerations? • What are the causes of unreliable measures?

22. Fair value measures—reliability Reliability => users of financial reports can depend on the reported numbers to represent the economic conditions (events, transactions) they purport to represent • Representational faithfulness => correspondence between the measure and the phenomenon being measured • Verifiability => consensus among various measurers of the same construct • Implies low dispersion of independent measurements • Does not require that the measure can be vouched or confirmed to a separate source • Key issue: Can this reliability construct be made operational for auditors?

23. Problems in obtaining reliable measures • Lack of markets • Illiquid and/or inefficient markets for financial instruments • Lack of used asset markets for physical items • Lack of markets for intangible items • Licenses, landing rights, patents • Information systems that do not capture the necessary data • Focus on firm-specific transaction amounts, and do not capture data on market transactions external to the firm • Intrinsic error in the measurement tools (models) • Researchers and others can and should attempt to develop improved measurement tools • Management-induced error • Bias and fraud • Accountants lack expertise in using tools • Education of accountants focuses on allocation of transaction amounts, not measurement techniques

24. Financial reporting failures and legislative responses • Understanding the causes of reporting failures • Failures of governance • Examples: perverse incentives, inadequate internal controls, inadequate oversight • Failures of auditing • Distinguish failure to detect error from failure to report error • Failures of enforcement • Failures of standards • Defective guidance • Missing guidance • Example: missing guidance for consolidating special purpose entities

25. Principles-based standards • Viewed by some as a constructive response to financial reporting failures • Claim: U.S. GAAP has a “rules-based” or “check-box” mentality that encourages transaction structuring to subvert the intent of the standards • Example: leasing • Empirical issue: Prevalence of various forms of earnings management and/or financial reporting fraud. To what extent do reporting failures arise from: • Transaction structuring • Idiosyncratic judgments • Fictitious transactions (fraud)

26. Principles-based standards • Discussion paper available at FASB’s website (fasb.org) • SEC report available at SEC website (sec.gov) • Report refers to “objectives-oriented standards” • What would principles-based standards imply? • No scope exceptions? • Example: SFAS 133 provides for nine exceptions • Example: Some industries (e.g., insurance) have specific guidance, and are often exempted from standards that would otherwise apply • No treatment alternatives? • Examples: SFAS 115 (marketable securities), SFAS 95 (statement of cash flows), SFAS 123 (stock compensation) • Limited (or even no) implementation guidance?

27. Principles-based standards • What are the effects of detailed guidance? • Increased comparability? • Empirical question: what is the amount of comparability under the current reporting system? • How much comparability would be lost if the amount of detailed guidance were reduced? • Reduced necessity for professional judgment? • Would the amount and nature of preparer and auditor expertise have to change if the amount of guidance were reduced? • What are the implications for accounting education? • Reduced enforcement and litigation costs? • Enforcement => clear indications of what is expected • Empirical question: would less detailed guidance lead to more (or less) litigation?

28. Principles-based standards and the Sarbanes-Oxley Act of 2002 • Conjecture about the future • Sarbanes-Oxley Act => opens the door to federal laws (and regulations) that prescribe, in detail, officer and director behavior and responsibilities • Supersede the broad fiduciary duties of loyalty and care and the business judgment rule? • Detailed expectations about behavior => increased demand for unambiguous and comprehensive financial reporting guidance? • FASB attempts to move to “principles-based standards” • Increased ambiguity (and requirements for the exercise of professional judgment) about financial reporting guidance?

29. Concluding comments • Not always clear what is the most appropriate response to standard setting challenges • Convergence with international standards • Changes to U.S. GAAP in the absence of complaints or problems • Tangible and immediate costs imposed on preparers and users of U.S. GAAP • Accounting for increasingly complex arrangements • Defining the boundaries of the reporting entity • Fair values => issues of reliability and issues of auditability • Restore trust in financial reporting • Move to less-detailed principles-based standards versus attempt to provide even more detailed guidance, so that expectations are unambiguous • Take account of regulatory/legislative effects