A year of challenge and change for the FASB.

There was once a time, not so many years ago when accounting could be thought of as an essentially nonpolitical subject.

So wrote Professor David Solomons in a 1978 Journal of Accountancy article entitled "The Politicization of Accounting." In that article, Solomons argued forcefully--and

I believe persuasively--for neutrality in financial reporting, for "if it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed just as faith in speedometers would be destroyed once it were realized that they were subject to falsification for the purpose of influencing driving habits."

Today, as we reflect upon the lessons learned from the recent wave of corporate-reporting scandals, I believe David Solomons' words a quarter of a century ago ring truer than ever. For paramount among the many lessons to be learned from the reporting scandals and their wider impact on the investing public and the capital markets is that neutrality in financial reporting really matters. Neutrality matters not only to the viability of individual companies and the financial well being of their employees, investors, and creditors, but also to the overall stability and vitality of the capital markets and, therefore, to our economy and our society.

As I write this commentary, I am coming up to my first anniversary with the FASB as its chairman. I am grateful to the Editor of Accounting Horizons for providing me this opportunity to look back on the past year and reflect on the many challenges we faced and to look forward as we attempt to chart the future course of U.S. accounting standard setting. We are hopeful that this course will enable us to better address the issues confronting accounting and financial reporting at this moment in history. Although this article describes many new things we are doing, the fundamental principle of neutrality in financial reporting is and must be a constant and rigorous guide to our standard-setting process.

THE IMPORTANCE OF NEUTRALITY IN FINANCIAL REPORTING

I believe that neutrality in financial reporting is a precondition for honest, trustworthy accounting information. That means our accounting standards must be free from bias that is aimed toward achieving a predetermined result or influencing someone's behavior or designed to achieve a particular political result. It is not a process of counting votes, although constituent input is critical to helping the standard setter understand the business transactions and economic phenomena involved and the relevance, reliability, and operationality of proposed standards. The process of setting the standards must acknowledge that standards setters serve the capital markets. Moreover, the goal in standard setting must be to set standards that will provide useful information to those markets at a reasonable cost. And once set, accounting standards must be applied based on steadfast adherence to the principles embodied in those standards without regard to the effect of financial reporting on market values or human behavior. Without a doubt, the primary concern must be the relevance and reliability of the reported information, not the potential effects of the information on particular interests.

THE CHALLENGES BEFORE US

The recent spate of major financial reporting scandals produced real challenges for those involved in the financial reporting process. Many, if not most, of the financial reporting problems stemmed from outright GAAP violations, apparent audit and corporate governance failures, structuring of sham transactions by investment bankers, and research analysts' conflicts. These problems also prompted broader questions and concerns about virtually every aspect of our corporate reporting system, including accounting standards and the standard-setting process. I think those questions were both appropriate and overdue. These broader questions related, in part, to the propriety of existing guidance on specific technical subjects--accounting for special-purpose entities, guarantees, and broader topics like revenue recognition, pension accounting, employee stock compensation, reporting of financial performance, and the use of fair value measurements in accounting. Very importantly there were many questions about the whole approach to, the structure of, and the processes relating to the setting of accounting standards in this country. It is on these more macro issues that I will focus my observations in this commentary, for I believe that our ability to successfully deal with them will transcend our day-to-day deliberations on specific technical issues.

Perhaps the greatest challenge facing the FASB and our Trustees during 2002 was a challenge to the continued existence of the organization in its current form. Troubles in financial reporting inevitably give rise to finger pointing, and as noted above, some of those fingers pointed at the FASB. On the one hand, many in the corporate and auditor communities argued that the Board was not sufficiently responsive to:

* their concerns about disclosure overload, operationality, and auditability;

* cost-benefit considerations; and

* their criticisms of particular accounting approaches that, in their view, did not properly reflect the operating realities of business.

On the other hand, many investors and other users of financial information saw things quite differently. In their view, the Board was too slow and not forceful enough in making needed changes to accounting standards and, being overly influenced by the preparer and auditor communities, produced standards that depart from basic principles, in part because they contain too many exceptions. They charged that the Board's timidity in standard setting enabled off-balance-sheet financing, inadequate disclosure, and form-over-substance transactions to proliferate. Implicit in these comments was a view that standard setting became too focused on the views of preparers and auditors and needed to be more attuned to the needs of investors and other users of financial information.

So, in an election year and at a time when accounting became front-page news, it was not surprising that many elected and appointed officials took a direct interest in the FASB. Numerous bills aimed at "fixing" various aspects of the corporate reporting system were introduced in Congress; some of these could have substantially altered the structure, processes, and specific technical activities of the FASB. The then-Chairman and the then-Chief Accountant of the SEC both publicly stated their intent to have the Commission more actively involved in the oversight and activities of the FASB, and President Bush's March 2002 ten-point plan on improving corporate responsibility stated that "the authors of accounting standards must be responsive to the needs of investors."

A key question was whether and to what extent accounting standard setting should remain in the private sector. Most seemed to agree on the importance of the neutrality and "independence" of the standard setter, but there was no consensus on the meaning of those terms. While many in Congress and many users of financial information emphasized neutrality and independence as keys to reducing the influence of preparers and auditors, those groups in turn were fearful that the FASB might effectively become an arm of the federal government and subject to all the attendant political pressures. What emerged as part of the Sarbanes-Oxley Act is, in my view, an appropriate balance. While providing for more secure funding for the FASB, thereby bolstering the Board's financial independence, the Act also emphasizes that this mandated funding is not intended to federalize the FASB or to put accounting standard setting in a position that might subject it to additional political pressures. Time will tell whether this is achieved.

As of the writing of this commentary, the effects of the Sarbanes-Oxley Act are still the subject of much debate and discussion. The Act effectively provides for the continuation of private-sector accounting standard setting. This was, in my view, due in no small part to the clear and consistent message delivered in Washington, D.C. by the FASB Board and the Trustees of the Financial Accounting Foundation. That message emphasizes the importance to the financial reporting system and to the investing public of standard setting that is directed toward establishing unbiased accounting standards by independent and qualified individuals in a process that is thorough, open, and neutral.

IF NEUTRALITY IS KING, THEN WHY DEAL WITH POLITICIANS?

Some believe that the mere act of engaging politicians in discussions about our mission and activities unnecessarily and inappropriately invites politicization of standard setting. My view is quite the contrary. All our constituents, including politicians, have a legitimate interest in our activities. But that interest must be in our properly fulfilling our mission of setting sound, neutral accounting standards, and not in trying to bias our activities and decisions. Through active discussion with all constituents not only do we learn their views about issues on our agenda, and about issues that require our attention, but we also are able to reinforce our key messages regarding independence, neutral standards, and transparency of our process. It is particularly important that we do so with those in Washington, D.C. As Solomons observed 25 years ago, "Because standards need to be set mainly in areas where there is controversy, it is highly probable that in every case someone will find the new treatment less favorable than the status quo and there is a constant temptation for such people to rush off to their legislative representatives to get government to interfere." In our society, lobbying one's elected representatives is viewed as part of the "American Way," so it is not realistic to expect the subject of accounting to be exempt from such activities.

ADDRESSING THE CHALLENGES

Although enactment of the Sarbanes-Oxley legislation in July 2002 was critical to the continued existence of the FASB as we know it, the FASB Board, staff, and Trustees fully recognized that there was much to do if we are to properly respond to the many questions and concerns raised about accounting standard setting in this country in the wake of the well-publicized corporate scandals. Such questions and concerns centered around:

* the timeliness of our processes;

* the proliferation of "rules-based" standards emanating from multiple standard-setting bodies;

* whether a more "principles-based" approach might lead to better financial reporting;

* the low level of involvement by investors and other users in the standard-setting process;

* the degree to which convergence of U.S. and international accounting standards should be pursued; and

* whether the existing reporting model should be replaced by, or supplemented with, a broader business reporting model.

In order to address these issues, challenges, and opportunities, in July 2002 we launched a series of reviews covering such matters as: (1) our approach to standard setting, including our agenda-setting and project management processes; (2) whether developing a more principles-based approach to standard setting would reduce the level of detail and complexity in U.S. standards; (3) what we can do to foster international convergence; and (4) increasing the level of investor and key user involvement in our standard-setting activities. We also broadly addressed other internal organizational issues relating to human resources, internal processes, and constituent relations. Moreover, as part of these reviews, we considered whether modifications in the structure of U.S. accounting standard setting, including the roles, composition, and processes of the EITF and AcSEC, would improve the overall quality and effectiveness of U.S. accounting standard setting. While those reviews were mostly the work of the Board and our senior staff, we actively sought and obtained input from a variety of other interested parties.

IMPROVING SPEED AND TIMELINESS

With regard to improving the timeliness of the standard-setting process, our Trustees took an important step in Spring 2002 by reducing the number of votes required to issue a Statement or an Exposure Draft from five to four. Additionally, the Board reorganized our senior staff to enhance both focus and accountability. Among other actions, this involved splitting the responsibilities of the single Director of Research and Technical Activities into three different roles, with one director focusing on major Board projects, another focusing on the EITF and other implementation activities, and a third focusing on internal processes, human resources, and special projects. Finally, we conducted a thorough process mapping of all our procedures with the objective of eliminating those that are redundant or do not add value, while at the same time not compromising our thorough open due process.

We also have been trying to address and resolve more issues at one time at our public Board meetings, and we have been spending more time together as a Board both in public "educational sessions" on agenda projects and in meetings on administrative and strategic matters. We believe that spending more time together as a Board will increase the efficiency and effectiveness of our work.

INCREASING THE INVOLVEMENT OF USERS IN STANDARD SETTING

Turning to constituent input, our meetings with constituents are now focused more on the identification of emerging problem areas and trends. While the Board has always received significant and valuable input from preparers, auditors, and regulators, over the years we have heard considerably less from users. Therefore, to obtain more active user involvement, we established the User Advisory Council. To gather nominations for the council, I wrote to the CEOs of the 25 largest mutual fund groups, the major investment and commercial banks, the rating agencies, and other groups that represent investors and other key users, soliciting names of candidates to serve on this new User Advisory Council. The Council had its first meeting in February 2003, and we are now using it to solicit input on our agenda and on specific technical projects.

"PRINCIPLES-BASED" STANDARDS?

There has been much discussion about principles-based accounting standards. As I suggested above, many express concerns that U.S. accounting standards are too detailed and too complex. They say it is increasingly difficult for both preparers and auditors to stay current, in order to comply with an ever-expanding set of rules. Further, there are concerns that this detail and complexity has fostered a "check the box" mentality that encourages financial and accounting engineering to structure transactions around the rules to attain form-over-substance results. Finally, some point out that many standards include numerous exceptions--to accommodate the concerns of particular constituents, to limit the volatility in reported income, and to mitigate the effects of transitioning to new accounting standards. Although I believe that many of those criticisms are legitimate, they should be evaluated in the context of both the demand for and the supply of financial reporting guidance.

On the demand side, the current state of U.S. GAAP reflects requests from the FASB's constituents, solicited as part of our open due process. On the supply side, the current standards and rules emanate not only from the FASB, but also from the EITF, AcSEC, and the SEC staff. People argue that their particular circumstances require exceptions to the standards, and companies and auditors fearful of second-guessing by the SEC and the trial bar seek bright lines, clarity, and detailed implementation rules. Accordingly, any attempt to move to more principles-based accounting standards must address not only the FASB's behavior, but also the wider issues pervasive among all participants in financial reporting.

As I previously mentioned, our internal reviews specifically included the subject of principles-based accounting standards, and the Sarbanes-Oxley Act requires the SEC to evaluate the feasibility of implementing such an approach in the U.S. We have been working closely with the SEC staff on this matter. In October 2002 we issued for comment a proposal on principles-based standards, and we held public roundtable discussions in December. The proposal sought to better define what we mean by principles-based standards, including the format, style, content, and level of detail in the standards. In my view, a principles-based approach starts with laying out the key objectives of good reporting in the subject area, allows for few, if any, exceptions, and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles.

The October 2002 proposal also touches on how moving to a principles-based approach could affect the role, approach, and processes of the EITF and AcSEC and on the FASB's own implementation activities. Finally, and very importantly, the proposal examines the implications for the behavior and actions of other parties in the financial reporting system, because successful implementation of a principles-based approach requires major behavioral changes by virtually all constituents. It requires preparers, auditors, audit committees, and boards to be willing to exercise professional judgment, to resist the urge to seek specific answers and rulings on every implementation issue, and to view accounting and reporting as an exercise in good communication that goes beyond mere compliance. It requires that investment bankers and the accountants and lawyers that work with them stop trying to invent ways to create products and structures to "loophole" standards, and it may require that the SEC staff temper their demands for bright lines to facilitate their review and enforcement activities. Moreover, it may require some changes to the legal and litigation framework surrounding financial reporting and auditing.

POTENTIAL ADVANTAGES OF A PRINCIPLES-BASED APPROACH

Having been an auditor both in the U.S. and in the U.K, and a standard setter both in the U.S. and at the IASB, I believe that there are many potential advantages to a properly implemented more principles-based approach. These include:

* Allowing, indeed demanding, that companies and auditors exercise professional judgment should enhance professionalism in both the reporting and auditing of financial statements;

* Easier-to-understand accounting standards;

* Reduced opportunities for form-over-substance structuring and arbitraging of rules because of (1) fewer exceptions to the principles and (2) the reduction in the number of potentially conflicting rules;

* Reduction (or elimination) of the potential double jeopardy that preparers and auditors could face in situations in which compliance with detailed rules may not be sufficient to avoid enforcement and litigation if the substance is lacking; and

* Convergence with the IASB and other major national standards that already use more of the "principles-based" approach.

POTENTIAL DISADVANTAGES

There are also some important potential disadvantages to a principles-based approach to standard setting. Some point to recent events in the U.S. as evidence that preparers and auditors cannot be trusted to properly exercise professional judgment with objectivity and courage. Others fear comparability could be reduced, both because of different good-faith judgments about the appropriate accounting treatment, even given similar facts, and because the generality of standards leaves more room for different interpretations by preparers and accommodations by auditors. Of course, these differing interpretations could be explained in disclosures, but this approach has the disadvantage of significantly increasing the number and complexity of already dense disclosures.

Finally, it simply may be harder to properly enforce a principles-based system. Enforcement agencies, such as the SEC, must understand and make judgments about firm-specific interpretations of general standards applied to firm-specific arrangements. This process takes more time than the (already considerable) time required to decide if a given registrant followed a clearly written rule.

In the end, I believe that whether a more principles-based system is worth the effort to develop and implement depends on whether the result is financial reporting that is more useful, more understandable, and more neutral--and, thus, more honest and trustworthy to investors and other users. I personally favor such an approach, but I do not discount the hurdles in properly implementing it in this country. At the time I wrote this article, the SEC was completing a report to Congress on this subject. I expect the SEC to take a middle-of-the-road approach, recommending a combination of principles and detailed guidance and charging the FASB with more clearly articulating the key objectives or principles in our standards, while still providing sufficient guidance and rules where appropriate to facilitate faithful implementation of the principles and objectives. Accordingly, we have embarked on a number of initiatives aimed at improving the quality and understandability of our standards and the robustness of key aspects of the conceptual framework relating to recognition and measurement, relevance, and reliability.

ACHIEVING INTERNATIONAL CONVERGENCE

As noted above, a more principles-based approach could help in the drive for international convergence of financial reporting. On the one hand, the growth of cross-border investing and capital flows, coupled with a growing endorsement of international standards, means that the U.S. cannot unilaterally develop accounting standards. On the other hand, the nature and global role of the U.S. capital markets require that the U.S. be a very active participant in the convergence process. There can be no truly international accounting standards if the largest capital market in the world, the U.S., is not part of their development.

Accordingly, the FASB is dedicating significant resources at various levels to this effort. We developed procedures and protocols used not only by us, but also by the IASB and other major national standard setters in working together. We are working with the IASB on several major joint projects, including business combinations, revenue recognition, and reporting on financial performance, and we are closely monitoring the progress of the IASB on other key projects. As part of our work with the IASB, in October 2002 we formally agreed with the IASB on two key initiatives. First, we agreed to try to align our agendas, a long-term initiative that will begin to show effects as major projects are completed. Second, and in the interest of accelerating convergence, we agreed to undertake short-term projects jointly with the IASB and with the support of the SEC staff, to eliminate or narrow some of the hundreds of existing differences between current U.S. and international standards. Although we hope to issue an Exposure Draft in the near future covering the first batch of those differences, realistically, this effort will continue well beyond 2005 when Europe adopts international standards en masse.

For the FASB, international convergence is a major strategic initiative that presents significant logistical challenges and requires increases in both our people and monetary resources. However, convergence is an imperative--we cannot avoid this effort. The trick, I think, is to work toward convergence in a way that does not significantly delay or dilute our efforts to improve U.S. standards, and by working with our international colleagues hopefully we can produce better standards that can be applied both here and across the world's major capital markets. And while most people seem to support international convergence, we all recognize that it will not be easy to achieve because by definition it involves choices between existing standards. Inevitably, changes to both U.S. GAAP and international standards will result.

IMPLICATIONS FOR THE STRUCTURE OF U.S. ACCOUNTING STANDARD SETTING

The structure of U.S. standard setting should be responsive to concerns (1) stemming from recent financial reporting and auditing failures, (2) about convergence, and (3) about the volume and complexity of U.S. standards. Part of the third set of concerns derives from the fact that rules come from several different bodies, in many different forms. U.S. financial reporting standard-setting bodies include the FASB as the full-time, primary standard setter; the AICPA's Accounting Standards Executive Committee (AcSEC) as a part-time, senior standard setter that addresses both particular industry matters and, from time to time, much broader topics; and the Emerging Issues Task Force (EITF), a part-time standard setter that addresses emerging issues and areas of divergence in practice; and the SEC staff.

These four bodies promulgate the standards and rules that make up U.S. GAAP in a variety of forms--FASB Statements, Interpretations, and Technical Bulletins, FASB staff announcements and Implementation Guides, Opinions of the Accounting Principles Board (APBs) and Accounting Research Bulletins of the Committee on Accounting Procedure (ARBs); AcSEC Statements of Position and Industry Audit and Accounting Guides; EITF Consensuses; and SEC Staff Accounting Bulletins, Accounting Series Releases, Financial Reporting Releases, and SEC staff speeches and announcements.

After analyzing the structure of U.S. standard setting, the FASB concluded that concerns about the number and complexity of sources and forms of financial reporting guidance are valid and that the FASB as the primary accounting standard setter should take responsibility for realigning this structure. The intent of this realignment is to better control the proliferation and consistency of standards and rules and, in line with the movement toward international convergence, to ensure that as new U.S. standards are developed they do not unnecessarily create new areas of divergence between U.S. GAAP and international standards. Further, if the FASB adopts a more principles-based approach to standard setting, the work of other standard-setting bodies should be consistent with that approach and not undermine it. To their credit, over a year ago the SEC staff indicated a willingness to refrain, as much as possible, from setting standards through speeches or staff announcements and even, wherever possible, via formal accounting releases.

Our first steps toward realigning the structure of U.S. financial reporting standard setting involved AcSEC and the EITF. Although we are very appreciative of AcSEC's valuable contributions, we concluded that its role as a second senior-level GAAP standard setter should, after a transition period, be discontinued and that the maintenance and development of any industry-based standards in the future should reside with the FASB. Even though the AICPA may choose to continue to issue industry Audit and Accounting Guides by way of implementation guidance, it will cease issuing Statements of Position that create new GAAP. As AcSEC has in the past, we expect to use the work of properly constituted industry-based task forces to assist us in our efforts. We have worked with the AcSEC chair and the AICPA staff to fashion an orderly transition plan.

With regard to the EITF, the FASB concluded that it serves a valuable function in helping to raise and resolve emerging and troublesome practice issues. We also concluded that more direct involvement by the FASB in the EITF's agenda, in the course of its deliberations, and in ratifying its final consensuses, is in order. We implemented changes that should allow all of us involved in financial reporting to continue to obtain benefits from the work of the EITF while at the same time making sure that its activities and conclusions are consistent with those of the FASB. Further, we broadened the composition of the EITF to include user representatives to ensure that this perspective is properly considered.

BEYOND FINANCIAL REPORTING

Last, a few words about the subject of business reporting and the broader realm of corporate reporting, modernization of the reporting model including greater disclosure of nonfinancial information, key performance metrics, and information on business value drivers, and the whole subject of electronic delivery and XBRL. In The Value Reporting Revolution, Moving Beyond the Earnings Game, (1) my coauthors and I urged the private sector to modernize the whole reporting system. In a related effort, the FASB led a major project called the "Business Reporting Research Project," which included a survey of current practices in voluntary disclosure of key nonfinancial information, a report on electronic distribution of financial and other information, and an analysis and set of recommendations to eliminate redundancies between current SEC and GAAP requirements and streamline information provided in disclosure documents.

As should be apparent from my descriptions of the FASB's activities, we are currently very busy just with regard to financial reporting and, while we stand ready to assist in the further development of the broader area of corporate reporting, my honest assessment is that currently we do not have the resources to lead this development, nor are we the best positioned to do so. Rather, I think various private-sector groups need to work together in this effort. I also think that some regulatory stimulus could go a long way to getting the ball rolling in this area. For example, perhaps the SEC could institute a broad requirement for companies to disclose and discuss their primary business value drivers and key performance metrics.

SOME FINAL THOUGHTS

I hope it is evident from this discussion that the past year has been challenging for the FASB. We approached our tasks and responsibilities with a sense of urgency and a commitment to doing everything we can to properly play our role in improving financial reporting. I think this is manifested both in our technical activities and in the way we set about trying to chart the future course for standard setting in this country. Three strategic objectives--improvement, simplification, and international convergence--are driving our agenda and activities.

Although we certainly hope and believe we are on the right track, in the final analysis our continued legitimacy depends on our ability to properly fulfill, and be perceived as properly fulfilling, our mission of establishing sound, neutral standards that help meet the needs of investors and other users of financial information. And, in turn, our ability to achieve this objective depends, in my view, on having qualified Board members supported by competent staff who deliberate issues and reach conclusions in a neutral, thorough, and transparent manner. It also very much depends on our ability to identify, understand, and address on a timely basis new business arrangements and transactions and economic and social trends that affect accounting and financial reporting. This, in turn, requires that we actively seek input from our constituents. We do this not to seek their approval, but to better understand the business and economic phenomena that are the subject of sound, neutral accounting standards.

I end with these two propositions:

* First, neutral financial reporting is the bedrock of our system.

* Second, independent accounting standard setting that is free from undue constituent influence or political pressure and that is conducted in a systematic, thorough, and open due process is an essential ingredient to achieving the first proposition.

In the end, a neutral accounting standard-setting process is needed to produce sound accounting standards that, if applied faithfully, will result in financial statement information that serves the needs of the capital markets.

(1.) Eccles, R. G., R. H. Herz, E. M. Keegan, and D. M. H. Phillips. 2001. The Value Reporting Revolution: Moving Beyond the Earnings Game. New York, NY: John Wiley & Sons, Inc.

The views expressed in this commentary 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 deliberations.

Robert H. Herz is Chairman of the Financial Accounting Standards Board.