All derivative financial instruments are assets or liabilities based on their fair value.
Gains and losses on those instruments are reflected in income in the same periods as offsetting losses and gains on qualifying hedged positions.
These two relatively straightforward statements are the essence of FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities , an excellent pronouncement that will result in long-needed improved financial reporting in this important area. However, one drawback is that the statement runs 245 pages long, much of it among the most complex text of any accounting standard to date.
Many pages of Statement no. 133 are devoted to examples of how the standard applies in certain contexts. Another hefty section, Basis for Conclusions, includes FASB's reasoning for its positions. These sections are helpful to implementing Statement no. 133. However, accountants must carefully read and understand all 245 pages to ensure that the statement is adopted properly, a formidable challenge even for those relatively few accountants with a good understanding of derivatives.
In addition to the length and complexity of Statement no. 133—or more likely because of them—FASB had all the Big Five accounting firms help it prepare an educational course on the new standard. A FASB-sponsored derivatives implementation group began meeting in early September and is expected to develop even more detailed interpretations. The FASB's emerging issues task force (EITF) and the SEC accounting staff may weigh in with still more guidance in time.
Regrettably, this level of complexity of generally accepted accounting principles has become more the norm than the exception. For example, FASB Statement no. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities , specifies when assets can be considered sold for accounting purposes and thus removed from the balance sheet. Although Statement no. 125 is very detailed, after it was issued many parties asked FASB to be even more specific about the accounting for securitizations and certain other common transactions, so the EITF developed several interpretations. FASB itself is in the process of amending the statement in certain respects, and a document has been recently issued by FASB staff covering numerous other implementation questions and answers. All of this is designed to help accountants apply the fairly basic concept in Statement no. 125 that assets are considered effectively sold when they are no longer controlled.
It is not only the length or complexity of FASB standards that creates the challenge for companies, auditors or others attempting to apply GAAP in good faith. The number of different sources of GAAP creates an added challenge. No longer is it possible for a CPA to pick up a single publication and find all the pertinent information on a given subject. In addition to FASB statements, all the following sources may also apply:
- FASB interpretations
- FASB technical bulletins
- FASB staff question-and-answer publications
- EITF consensus positions
- Announcements by FASB or SEC staff members at EITF meetings
- AICPA statements of position
- AICPA practice bulletins
- AICPA audit guides
- SEC staff accounting bulletins
Even more problematic is that the SEC expects public companies to follow guidelines set out in speeches by SEC accounting staff members at various conferences, particularly the annual AICPA National Conference on Current SEC Developments.
Thus, interested parties must search the above sources—and perhaps others, too—to see whether there is accounting literature on point and then decide how it applies to the issue under consideration. While computers help greatly in the identification of applicable literature, humans still must read the material and decide how it should be interpreted.
What is causing this explosion in the sheer volume of accounting literature? Even more important, why has the literature become so complex?
WHY SO MUCH DETAIL?
The main reason for the increase in the volume and complexity of accounting guidance is that many auditors, corporations and regulators ask for it. They want to have clear answers for nearly all possible situations they might encounter. While most business people and senior partners of audit firms support general principles in theory, they often ask for much more detailed standards in practice.
One explanation for this is what I call the show me syndrome: the tendency for many companies or auditors to treat accounting standards as a book of laws and take the position that an accounting treatment not explicitly prohibited must be permissible. Thus, we sometimes hear clients say to their auditors show me the specific rule that says I cannot do so-and-so.
The SEC also tends to seek the maximum in uniform application of accounting standards, even those that include inherently subjective aspects. Many of the issues brought before the EITF result from specific requests for clarification from the SEC accounting staff. Sometimes they come about because the SEC challenges a particular registrant or accounting firm and the registrant or firm asks the EITF to resolve the differences of opinion.
One additional explanation FASB often cites for complicated standards is that corporations lobby aggressively for desired financial reporting outcomes, such as smoothing the effects of transactions on periodic net income. FASB argues that to accommodate such concerns it must include many more details than it otherwise might prefer to do in certain accounting standards, such as those on pensions, other postretirement benefits, and, most recently, derivatives and hedging. FASB says that if it did not have to provide for what a large number of constituents believe is the best matching of income and expense in the income statement, it would be able to issue much shorter and easier-to-apply standards in many cases.
But perhaps the best explanation for creeping complexity of accounting standards is that business itself has become so much more complex. Derivative financial instruments and securitization transactions, for example, are inherently complicated and may not be adequately covered by general accounting principles. And actions taken by companies to sell their products internationally, protect against a multitude of financial and other risks, adjust to new technology and react to other developments often raise new accounting issues.
Accounting standards setters, encouraged by questions from auditors, company representatives and the SEC, consequently are tempted to go overboard and pursue uniformity past the point of diminishing returns. The result is rules that only a specialist can interpret and accounting that may lose sight of the objective of meaningful reporting. In fact, many parties suggest that detailed rules only encourage loophole identification followed by even more rules.
Rather than accede to the many requests for answers to all possible situations, the FASB should ask itself whether more detail will result in better financial reporting. The answer could be a resounding no if the complexity of new accounting rules outpaced the ability of well-intentioned professional accountants to keep up with and understand them or discouraged appropriate professional judgment.
SIMPLICITY AS A STRATEGY
In 1992 FASB preliminarily addressed many of the concerns of constituents through a three S program—for selectivity, speed and simplicity. Selectivity meant dealing first with the issues that could most improve financial reporting. Speed meant completing projects more quickly. Simplicity meant making accounting standards simpler and shorter.
When in 1996 FASB adopted a formal strategic plan it included some goals from the three S program. Unfortunately, simplicity seems to have since fallen through the cracks.
BALANCING STANDARDS AND JUDGMENT
Professional judgment and common sense augmented by analogies to other standards can guide the accounting for many new accounting issues. Most parties agree that financial reporting is not useful unless there is a reasonable degree of comparability from company to company. Readers cannot place much credibility in financial statements if, for example, one company decides that an expenditure qualifies as an asset and another company decides that the same expenditure is a current period expense. However, almost all accounting rules require some degree of professional judgment in their application. The challenge to standards setters is to provide enough specifics to ensure parallel application without going overboard on detail.
HOW TO SIMPLIFY
Simplification is, of course, easier said than done. Making accounting standards simpler at the same time that the business world grows more complicated each day may seem like an impossible dream. In the past I have heard suggestions such as the following:
- Limit the number of new pronouncements per year.
- Limit the size of individual pronouncements (some who suggest this point to the good old days when standards on pervasive subjects often were only a few pages long).
- Insist that for each new pronouncement at least one older rule is eliminated.
In my view, such arbitrary approaches would lead to better financial reporting only by accident.
Still, FASB must at least begin reversing the complexity trend. Perhaps the most important step would be for the FASB to just say no to many subsidiary questions. This could result in less-detailed statements if third- or fourth-level issues are not specifically addressed, as they are in many standards at present. It also could result in fewer pronouncements if those that dealt only with very narrow issues were not issued.
Not addressing every possible issue will require corporate financial executives, auditors, regulators and other interested parties to recognize that professional judgment must play a more important role in financial reporting. At the same time, corporations and auditors, in particular, must continue to earn the trust of users of financial statements that judgment will not be abused. Also, all interested parties, not just the FASB, must assume a large part of the responsibility for simplification. They must make specific suggestions on how to simplify individual standards as well as the overall reporting framework without diminishing the quality of information to users. And they must be willing to actually accept general principles and apply them in good faith, which includes resisting the temptation to invoke the show me notion.
Finally, perhaps it is again time for a comprehensive codification of accounting standards. Accounting Research Bulletin no. 43, Restatement and Revision of Accounting Research Bulletins , was the last such compilation, and it was issued nearly half a century ago. If such all-in-one-place guidance were put together, FASB or other groups doing the job might even find that there are quite a few standards that have outlived their usefulness and can be eliminated.
DENNIS R. BERESFORD is Ernst & Young executive professor of accounting at the University of Georgia in Athens. He served as chairman of FASB from 1987 to 1997.