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Robert Herz started his new job as chairman of the accounting industry's main rulemaking body, the Financial Accounting Standards Board (FASB) on July 1, when accounting practices were facing what has remained an ongoing firestorm for their role in the massive bankruptcies and corporate scandals that have marked the year (see BW Online, 8/19/02, "The Substantial Issue of Intangibles").
The FASB has always maintained a low profile. And the low-key Herz, 48, an expert in technical accounting and financial reporting who formerly was a senior partner at PricewaterhouseCoopers, is likely to continue that tradition. But while Congress and the Securities & Exchange Commission (SEC) have generated many of the recent headlines with their new rules, the FASB has quietly made significant reforms in several key areas this year.
Herz personally favors a move toward what is known as "principles based" accounting. That entails a kind of vast simplification of accounting rules, or standards, as the FASB refers to them, where professionals would be asked to comply with broad goals and objectives -- not a lengthy list of rules and exceptions. The result would be standards that might run to no more than 12 pages, instead of stretching to as many as 200 pages. There would be no exceptions and far fewer loopholes.
The idea is controversial. Herz recently discussed these issues with BusinessWeek Online associate editor Amey Stone in a phone interview. An edited version of their conversation follows:
Q: What improvements in financial accounting do you think are necessary in response to the wave of scandals now plaguing Corporate America?
A: The first thing I would observe is that with most of the scandals, breaking the rules is at the core. When a person or company just outright violates standards and commits fraud, it is hard to say the standard is wrong. It's like when someone robs a bank: You can't really say that the law against bank robbing was part of the problem. But there are some opportunities to improve existing standards that have become clear.
Q: Accounting for stock-option expense is high on your list. Can you describe your plans there?
A: We are doing a bunch of things related to that. First, we have tried to give some guidance to companies that want to change to the better method of expensing options. [Including options expenses on the income statement is FASB's preferred method, but simply recording it in the footnotes of the annual report, a method many prominent companies are foregoing, is still allowed.]
The second thing we're trying to do is improve -- by making more prominent and clear -- the disclosure related to a company's policy for accounting for stock-option expenses. How much expense is it recognizing? Where is it in the financial statements? What expenses would there have been if it had used a full "fair value" approach? Analysts told us they would like to see a lot of that information, not just in the annual report, but quarterly.
[On Aug. 14,] we decided to put together a proposal. We will get some comment on that and, at the end of September, we plan to issue a draft of new rules. We should be able to finalize it by the end of the year.
Q: Do you expect to require all companies to include stock-option expenses on their income statements?
A: Our current proposal still doesn't deal with that fundamental question. The International Accounting Standards Board (IASB) is heading toward that requirement. Once the IASB issues its rules later this year, we'll put out another document explaining the differences between current U.S. rules and the ones the IASB will be proposing. We'll get comments on that, then we'll try to figure out what we'll do.
Q: What do you think the final result of new rules on stock-option accounting will be?
A: I think the changes will alter some companies' behavior in terms of, not only the number, but also the kind of incentive plans they offer. The way the rules are now, companies get to use a more favorable accounting treatment for the more valuable kind of options -- those that simply vest over time. That encourages companies to issue the plain stock options vs. those that vest not only with time, but also require the company to achieve a measure of outperformance over its peers or the market. When we change the accounting, companies should become much more focused on the underlying value of what they are providing and use options to encourage what seems to be better behavior.
Q: What are other accounting reforms you're looking at now?
A: Special-purpose entities (SPEs) is one area we've tackled. Although Enron violated the so-called 3% rule [which said that only 3% of the funds to set up these minicompanies needed to come from outsiders for it to qualify as independent and remain off-balance-sheet], we looked at it and decided the 3% rule doesn't make a lot of sense. We are now requesting comment on a proposal that makes some pretty radical changes in that area. It should lead to companies including a lot more of these entities in their consolidated financial statements.
Another topic in which there seems to be regular and continuing issues and problems -- often fraud -- is revenue recognition. We've undertaken a very major project to completely relook at existing accounting guidance in that area. Guarantees, such as loan guarantees where one company guarantees another's loan performance, are another problem area. We will have out a final standard on that in the next few weeks that improves both accounting and increases the amount of disclosure related to those kind of guarantees.
Q: You mentioned at a recent conference that one of your main goals was to move toward "principles-based" accounting. Can you explain that concept?
A: A principles-based system is one where the accounting standard simply lays out objectives of good reporting in an area. It may include some rules, based on the objectives, but it doesn't try to answer every question or provide a rule for every situation. So the standard would be more like 10-to-12 pages than 200 pages.
We would tell people that, if you can't see a particular rule to fit your situation, go back to the main objective or principle. There are no exceptions to the basic principle. It would be very different than standards now. This is something the Sarbanes-Oxley legislation requires the SEC to study. The FASB and the SEC will be working together on that -- exactly what it means and what the implications are. My own view is that it probably wouldn't mean rewriting existing rules. It would apply, going forward, to new standards and amendments of old standards.
Q: Why do you think it would be an improvement over the current system?
A: It is aimed at eliminating the vast array of exceptions we have in the existing standards. Right now...rules are issued by four different bodies and we have thousands of pages of rules. The problem with that, in my view, is that for those who want to comply with rules, they are not always sure of everything they need to look at. One rule may contradict another. Those looking to get around the rule...can use legalistic approaches to try and do it. So the current system has downsides for those who want to comply with the rules and benefits for those who don't want to. A more objectives-oriented system with few exceptions would provide fewer loopholes.
Q: It sounds like a great idea. Why is it so controversial?
A: The flipside is it requires the exercise of good judgment by both companies and auditors. Those who don't like a principles-based approach say, "I don't trust people to do that." They think people need rules to follow or they will try to find a way to make an objective fit almost any situation. But principles-based accounting is used in other parts of the world where they seem to have, on the face of it, fewer problems than we have.... A principles-based approach is untested in the U.S., but, intellectually, it would seem superior.
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