Wrong-Headed Reactions to Information Overload Threaten Sound Decision-Making

By Barry Jay Epstein

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MARCH 2007 - A long-running debate about whether to develop a unique set of financial reporting standards for small and medium-sized entities (SME) or, alternatively, to extract from existing standards [e.g., U.S. GAAP or International Financial Reporting Standards (IFRS)] a slimmed-down set of requirements to serve as these enterprises’ primary source of guidance, has gathered considerable steam over the past several years and may be headed for resolution over the near term.

The issue centers on the perceived complexity of modern financial accounting requirements, which some believe exceeds the ability of preparers and auditors to fully comprehend, and which arguably serves to make financial statements and the accompanying footnote disclosures incomprehensible to management and outside users. Some have reacted by urging a reduction and simplification of GAAP, especially for entities that have a low risk of misleading users.

For example, some recommend a size test, a system now used in the United Kingdom, which in late 1997 promulgated, as Financial Reporting Standards for Smaller Entities (FRSSE), a single standard containing excerpts from much of existing U.K. GAAP. Even this simple suggestion has complications, however: Size could alternatively be determined by total assets, revenues, net worth, the number of shareholders, or other factors. Others recommend that publicly traded entities, regardless of size, should be compelled to follow a more comprehensive set of standards than privately owned businesses. The so-called “Big GAAP versus Little GAAP” controversy has waxed and waned for over 30 years in the United States and has now been taken up globally by the International Accounting Standards Board (IASB).

Complexity Versus Simplicity

At its heart, the debate springs from the perception that U.S. GAAP (and the corresponding and largely similar IFRS) has, by inadvertence or ineptitude, grown far too complicated: There are, or should be, simpler ways to measure and report economic transactions. This proposition is highly debatable, however, because it has not been the actions of accounting rulemakers but rather the ever-increasing complexity of business transactions that has for the most part necessitated these newer and admittedly complex requirements.

One obvious example is the growing use, even by smaller businesses, of “engineered financial instruments” such as forwards and options (e.g., currency forwards used by importers of products to protect against currency fluctuations when purchase obligations are denominated in foreign currencies). Engineered financial instruments have necessarily resulted in complex standards on hedging transactions. (Note that the adoption of comprehensive fair-value accounting would obviate the need for special hedge accounting. In the wake of Enron, however, this once-anticipated near-term goal seems to have receded into the distant future.)

The debate acquired added urgency when the flurry of financial reporting frauds in the United States in the late 1990s and early 2000s focused attention on the differences between principles-based and rules-based accounting standards. At the time, some IFRS enthusiasts cited the largely U.S.-based frauds as evidence for the proposition that detailed financial reporting guidance, containing a plethora of mechanical rules, actually offered more, not fewer, opportunities for financial reporting shenanigans. This hypothesis was largely debunked by an SEC study (mandated by the Sarbanes-Oxley Act) which concluded, logically, that useful standards must be based on sound principles but almost inevitably will also require a fair amount of detailed guidance.

The subsequent burst of financial reporting frauds by non-U.S. companies (e.g., Parmalat, Royal Ahold) also served to undermine the reputation of principles-based standards. Nonetheless, the perception that the complexity of accounting standards had surpassed many preparers’, auditors’, and users’ comprehension persists, and both U.S. standards-setting bodies (FASB and the AICPA) and the IASB subsequently undertook SME-type projects.

The U.S.-based project has been slower to develop, and FASB appears cautious about supporting differential GAAP for privately held or smaller entities, but does acknowledge a grassroots enthusiasm (based on an AICPA survey that found a majority in favor of “some” differential GAAP) among constituents for distinct GAAP for private reporting entities. FASB also appears to be motivated, in part, by the IASB’s undertaking a somewhat more ambitious project on this topic. Nonetheless, to date FASB has seemingly focused principally on process—giving privately held businesses “a seat at the table” where standards are developed and discussed—and has offered no concrete indication that a unique set of standards for private companies is on the horizon. FASB has, however, suggested that “alternatives for private companies” will be put forward as new standards are developed, which may imply modest exceptions like those provided in the past (e.g., excusing private entities from reporting earnings per share and segment data, and providing slightly simplified computational methods for share-based compensation).

The IASB has long been the de facto standards setter for less-developed nations, and now—with the European Union’s endorsement of IFRS for 7,000 publicly held companies, and convergence or full adoption of IFRA by nations from China and Russia to Australia and Canada—it is rapidly becoming a truly worldwide arbiter of financial reporting. For its part, the IASB has demonstrated significant (if belated) concern for the burdens placed on reporting entities located in areas having resources (such as trained accountants and independent auditors) that may be inadequate. While FASB issued a brief invitation to comment in 2005, the IASB staff has exposed an internal draft comprising well over 200 pages of materials largely extracted from existing standards (IAS and IFRS) and interpretations (SIC and IFRIC), following the pattern set by the U.K.’s FRSSE, to provide a one-document solution for those qualifying reporting entities seeking accounting guidance.

Experiments in Standards Setting

Historically, when those advocating different sets of financial reporting standards have been challenged, they typically have been unable to identify alternative recognition or measurement principles for large (or public) entities versus those for smaller (or privately held) entities. At best, certain disclosures have been cited as candidates for “slimming down” in financial statements of smaller or privately held companies. In short, there may be less than meets the eye to this entire controversy.

In fact, FASB has experimented in recent years with differing standards for disclosures. SFAS 126, Exemption From Certain Required Disclosures About Financial Instruments for Certain Nonpublic Entities, exempts nonpublic companies from certain financial instrument disclosures if the entity’s total assets are less than $100 million and the entity has not held or issued any derivative financial instruments. Nonpublic companies also are not required to disclose earnings per share (SFAS 128, Earnings per Share), segment information (SFAS 131, Disclosures about Segments of an Enterprise and Related Information), or certain pension and postretirement information [SFAS 132(R), Employers’ Disclosures about Pensions and Other Postretirement Benefits—an Amendment of FASB Statements No. 87, 88, and 106]. These exemptions have not, however, been widely heralded as progress against the perceived evil of “standards overload.”

Those who oppose FASB and the IASB’s undertakings hold that differing standards would reduce the quality of financial reporting, and would possibly have other negative implications for both the reporting entities and the accounting profession itself. For example, if decisions about which entities should follow specific standards were made using a single criterion for all standards (such as reporting-entity size or ownership), then some entities that engage heavily in a certain type of transaction (e.g., the use of derivative financial instruments) might be exempted from the standards for that transaction even though the recognition, measurement, and disclosure of that transaction was critical to understanding the financial condition and the results of operations of that entity. To address that problem, however, criteria would need to be based in some way on the underlying subject of the standard; but this in turn would require that each accountant examine each standard to determine if it would apply to a particular entity under specific circumstances. That could compound the standards overload problem rather than solve it.

Any attempt to establish alternative financial reporting standards (under either U.S. GAAP or IFRS) for either small or privately owned companies is quite possibly doomed to failure, but it would serve as a huge distraction for standards setters in the interim, while raising false hopes among the intended beneficiaries and serving to denigrate the propriety of existing standards. This is not to suggest that improvements in all financial reporting standards should not be sought, as indeed there are many areas in obvious need of attention. It is a fallacy, however, to promote the idea that some entities are too small or lack the requisite public accountability to necessitate compliance with established GAAP or IFRS. The only rational basis for different sets of GAAP or IFRS involves the economic transactions and activities of the reporting entities themselves. For example, if a very small entity engages in complex hedging activities employing sophisticated financial derivatives, then the (admittedly complicated) requirements set forth by SFAS 133 (U.S. GAAP) or IAS 39 (IFRS) ought to be complied with—or, if the requirements are flawed, they should be revised, not just for specific entities, but for all.

Furthermore, the parallel existence of what will be widely viewed as two sets of financial reporting standards will contribute to the creation of a two-tiered profession, with some accountants coming to be seen as being qualified to deal with SME reporting, but not with “real” GAAP or IFRS issues. This could even impact the educational system, perhaps with the development of an abbreviated course of study for those who will become qualified for the SME level of work, versus a longer program for those aspiring to be experts on “full” GAAP or IFRS. This will artificially isolate some, probably smaller, practitioners, who may come to find that their credibility (say, with credit grantors) has become attenuated as a result.

Possibly the most deleterious consequence, although perhaps the least obvious one, will be the higher cost of capital to be borne by smaller entities—that is, those using “second-class” GAAP or IFRS, whose financial statements are being audited or reviewed by “second-tier” accountants. Cost of capital (bank loans, trade credit, equity infusions) reflects the perceived risk of the investment, which in turn is directly impacted by the quality of information made available to investors and creditors. The less complete such information is, the greater the perceived risk will be, and hence the higher the cost of capital, which will diminish the expected residual returns to the owners. In brief, it should be anticipated that banks and other lenders will punish companies that opt for less-than-“full” GAAP or IFRS compliance, even as (according to survey data) they claim to support, in the abstract at least, the idea of “simplified GAAP.”

Rededication to Education Needed

The pursuit of SME GAAP or IFRS is unnecessary and ill advised. Rather than attempting to impose a “Stop the world, I want to get off” solution to the problem of increasingly complex business structures and transactions, those involved in financial reporting need to rededicate themselves to educating preparers and users and, as necessary, to improving accounting standards for all affected parties. To the extent that promulgated IFRS (or national GAAP) is lacking, it should be fixed. If financial-statement preparers struggle with complex rules, independent accountants should help them gain the needed understanding. If lenders and other users of financial statements cannot cope with the more challenging aspects, then they should be educated (which itself presents CPAs with wonderful opportunities to market themselves to these premier referral sources). And if practitioners themselves are struggling with an increasing profusion of complex standards, then perhaps the educational systems are inadequate to the task, or there should be a more rigorous set of requirements for the continuing education of practicing professionals.

Fixing the perceived problem, if there really is one—and barring the impossible alternative of banning complex financial transactions—should not lead the profession to abandon its commitment to reporting on economic activities and their consequences. In the long run, only the pursuit of high-quality, universally ` relevant accounting standards will provide the foundation for optimal capital allocation and economic growth.


Barry Jay Epstein, PhD, CPA, is a partner of the Chicago firm Russell Novak & Company LLP. He is co-author of Wiley GAAP and Wiley IFRS, among other books. He can be reached at bepstein@rnco.com.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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