Whoever follows Edmund Jenkins as Financial Accounting Standards Board chairman faces a daunting task. With some blame for Enron's failure being laid at FASB's door, calls are coming for a severe restructuring of the board -- or even its replacement.
For now, the 66-year-old Jenkins, scheduled to retire when his 5-year term ends on June 30, remains hard at work implementing changes aimed at heading off that second scenario. Among the revisions taking shape are several designed to speed the board's reaction time when problems occur, such as reducing the board's size from seven to five members, replacing its current supermajority voting requirement with a simple majority, flattening its organizational hierarchy, and reducing the comment period on proposals to two months from three. Critics have cited FASB's sluggishness as a contributor to the Enron scandal, since a proposal to tighten rules governing the off-balance-sheet financing vehicles known as special-purpose entities, for example, had been under consideration long before Enron's abuse of SPEs was exposed. In response, FASB accelerated its review of SPEs shortly after Enron filed for bankruptcy.
But some critics demand more fundamental change. One proposal, in the House of Representatives, would increase FASB's government oversight, requiring the Securities and Exchange Commission to conduct annual reviews of unresolved accounting-standards issues. Another, in the Senate, would attempt to reduce outside influences on FASB's rule-making. The Senate bill would replace the current structure that funds the board using voluntary contributions from financial-statement issuers and accounting firms. Instead, predetermined issuer fees would pay for FASB.
For their part, issuers complain that the complexity and specificity of FASB's current rules encourage the very abuses they're supposed to prevent. At a recent CFO magazine conference in New York, for instance, Pfizer Inc. CFO David Shedlarz insisted that Enron's failure underscored the need for "a new financial reporting model."
CFO's interview, conducted by deputy editor Ronald Fink at the board's Norwalk, Connecticut, headquarters, occurred on what must have been a tough day for Jenkins. Shortly before, SEC chairman Harvey Pitt had told a congressional hearing that FASB was ineffectual and unduly subject to industry and political influence.
If this was disturbing to Ed Jenkins, his demeanor didn't show it. The white-haired, bespectacled chairman remained soft-spoken and unruffled--perhaps in anticipation of the prospect of an Arizona retirement. But while acknowledging that the board must revamp both processes and structure, he stoutly defends its recent rule-making on every front except stock options, where he concedes that FASB has succumbed to overwhelming political pressure. He points with particular pride to new rules on business combinations. And he strongly opposes any junking of U.S. generally accepted accounting principles (GAAP) in favor of something radically different.
Even so, Jenkins leaves little doubt that, at this stage of his career, he's got things on his mind other than championing the system.
Did you ever imagine when you took this job that accounting would be the subject of heated debate in the halls of Congress?
Even more amazing, it's on the front page of the New York Times. But it demonstrates the importance of accounting to the capital markets.
It seems not to have been so significant when the markets were going strong.
It was lost in the euphoria, I guess. Companies that didn't have any earnings were trading at multiples of something else.
Could you respond to the criticism of FASB that SEC chairman Harvey Pitt made in response to questions from Congress the other day?
I was surprised and disappointed that he would say then that we were ineffectual, because that's not what he said in his direct testimony. I testified [in earlier hearings] that we need to see what we can do to become more timely, and we are working with the SEC to help accomplish that.
As for independence, I would make the point that pressure from the accounting profession or from the business community is not in any way related to where our funding comes from. Funding is for us really a nonissue. Funding comes through the trustees. It doesn't have any impact on our decisions. But I can understand the perception.
What do you think of the proposal that's in the Senate to change the basis of your financing from voluntary contributions from issuers to fees imposed on them?
The trick is to find a source of funding that avoids the opportunity to increase the politicization of the process, which is a risk if the funding, directly or indirectly, is subject to the appropriations process in Congress.
In other words, this could merely shift the source of influence from industry to politicians.
Right, though I think that there may be ways to avoid that. In that sense, we are positive about the fact that Congress has recognized the need for us to have an adequate and stable funding source. And so we are certainly interested in working with them and the SEC and the trustees, as I've said.
What about the criticism that FASB should be setting rules according to broad principles rather than detailed guidelines?
The issue is, are you going to have principle-based standards and stop there? Or are you going to have principle-based standards plus a lot of detailed implementation guidance? Our standards today are based on our conceptual framework; the standards are enunciated in the standards portion of our documents, which are relatively short.
All of these hundreds of additional pages that you hear people talking about are really the additional details. So the question is, where do we draw the line in explaining how to apply the underlying principle that we enunciate? If we do very little explaining, it's going to require companies and their auditors to apply principles in good faith, to appropriately recognize the economics underlying the transactions that are subject to the standards, and to recognize that there will likely be more volatility in reported earnings. Much of the complexity and detail in our standards come from exceptions to principles that we make, in order to dampen volatility of reported earnings.
If you go to principle-based statements without detail, then people even in good faith are going to get somewhat different answers, depending on how they apply the rules to a particular transaction. Will the SEC staff recognize that companies and auditors are going to come up with different results--in some cases from the same transactions? The SEC has to have the power to do that. To their credit, both chairman Pitt and chief accountant Robert Herdman have said that they will. But that's been a concern. And no company, no auditor in particular in this environment, wants to subject itself to potential liability concerns that the issue seems to bring.
Criticism has been leveled at FASB for working on the consolidation project for 20 years. And some critics have suggested that one of the hang-ups has been SPEs. Has this project been subject to political or industry influence?
We have been working on a broad, multifaceted project on consolidations for 20 years. But special-purpose entities initially weren't even on the agenda. And in the last 10 years, we've issued two exposure drafts for comment that would have addressed SPEs. In both cases we received significant criticism from companies and the accounting profession, such that we felt that we couldn't go forward.
How would you characterize the criticism?
In many cases they criticized us for being too principle-based and not supplying enough detail. And in other cases they felt that the proposed rule would require consolidation when that didn't meet their objectives. But the proposal was probably not a whole lot different from what we are trying to do now.
There's a fine line between going forward [and] changing something because of pressure, and not going forward and changing something because you truly learned that what you planned to do is inoperable, or doesn't accomplish your objective. That's the purpose of a process that provides for open comment from constituents. It's a learning process. And to the extent that FASB learns and believes that what it hears is legitimate, then we have an obligation to respond. So listening to constituents--all types, including the business community--is important. And I think on the whole it has given us much better standards.
You can probably contrast this to the stock-option thing in the middle 1990s. There, when the board finally issued something, it acknowledged in the document itself that what it planned to do was preferable [compared with] what it was able to accomplish, and it clearly didn't go forward, because of pressure. So those were two different situations. But the difference is sometimes not clear.
It certainly seemed fuzzy in the debate over pooling.
The pressure there came in a different direction, not so much from Congress. But I believe at the end of the day that we ended up with a superior answer. Talk about a principle-based approach: what's the principle behind pooling? You amortized goodwill arbitrarily over X number of years, when there was no evidence that it was not still a valuable asset. The better principle, which we were able to establish, is that all business combinations are acquisitions by one company of another. So we were able to develop a principle-based approach to accounting for business combinations, out of the due process. And we also were able to withstand the political pressure that was brought to bear in that project.
Are stock options an agenda item for your successor?
As I've said in the past, we are following this issue, inasmuch as the International Accounting Standards Board has it on its agenda and is pursuing it. At such time as the IASB goes forward, if it does, our commitment to converge standards requires us to take a look and decide whether or not we should do something.
Wouldn't there be a need in any case to resolve the discrepancy concerning performance-based options? This seems to be a case where accounting and good governance are at odds.
It is an anomaly that the options that perhaps provide the most incentives for employees to perform are a compensation expense and fixed-price options aren't. But one thing that gives us some comfort is that disclosures are being made. And in light of Enron, analysts should perhaps be making more of that information than they have in the past. I thought it was really interesting that in his remarks to Congress, chairman Pitt talked on one hand about how we were subject to pressure from the business community, and on the other indicated that it might be a mistake to require the cost of stock options to be expensed. But I recognize that the chairman is under a lot of pressure.
You've proposed some specific changes in both the board's composition and its process. What will they accomplish?
We have already done a number of things. One is to institute new planning tools for our projects, designed to measure the progress we are making. We've adopted the idea of issuing a prospectus before we put things on our agenda, to seek comments from the public on their scope. We want to make sure we get the scope right in the first place, so we don't get halfway through the process and decide we need to address something else as well. We are also trying to see if we can't take projects in somewhat smaller chunks.
Can you provide an example?
SPEs are one. The intangibles project may be another, in that we are going to look at disclosures first, as opposed to the whole ball of wax. More broadly, we are reorganizing the top management of our staff, so the director responsible for the major projects will have more time to spend working with the project team directly.
One proposal in Congress would have you report annually to the SEC. How big a change would that represent?
What it requires is that the SEC report to Congress on whether we are addressing the right issues, whether we are making sufficient progress on those issues, and whether we have sufficient resources to do the job. FASB then is supposed to reply in a couple of months. The SEC right now has oversight over our process. Many of our agenda items come from what the SEC staff sees as they review filings. And they provide comments and participate in our process as we go forward. The difference is that this process will be documented. And I don't see that as necessarily a bad thing.
You've expressed concern in the past about federalization of accounting standards. Might this not represent a slippery slope toward that?
You have to be concerned about that, yes. But it's one thing for proposals to be directed toward our process. It's another for legislation to be directed toward the answers that we give. And that's what happened when we had standards legislated that said you should not expense stock options. That is significant interference that is inappropriate. So far, I'm not aware of any member of Congress, whether they've introduced legislation or not, who believes that FASB ought to be federalized.
Do you have any fears about accounting in light of what Andersen is going through?
I don't know at what point you have too few accounting firms. I would suspect that three would be sufficient, and that there will be one or two others that will begin to grow and to obtain more public companies as clients, so that over the long run the industry might come back to five or six top firms. So I don't see that as an issue. It would be if it got down to one, but I can't imagine that happening.
What about your work on fair value? Wouldn't this help make GAAP more of a principle-based system?
Absolutely. Fair value, at least for financial instruments--where we are focusing now--responds to a number of things that many others have been concerned about. We now fair-value some financial instruments. Others, we don't. That gives rise to different approaches to the balance sheet and the income statement, and in some cases liabilities that are funding an asset. That alone creates volatility in the financial statements, and it's why we then add to the complexity of comprehensive income for some of these changes in value. [And] if we had fair value for all financial instruments, we'd reduce the need for hedging guidance. There are significant measurement issues. If you have a mortgage financing a building, and you mark the mortgage to market but not the building, you get that discontinuity again.
Is outside pressure slowing the process?
Financial institutions don't like it. One argument they make has legitimacy: uniquely designed instruments that are not readily marketable are hard to value. But financial institutions more and more are using fair value to manage their businesses. Models for determining fair values are improving all the time.
How much of U.S. GAAP is, in fact, broken? There's an assumption in the wake of Enron that the system is faltering.
It seems to me that the system, and the standards that we have, are in pretty good shape. One thing we still don't know about Enron is why they didn't follow our existing standards.
What achievements are you most proud of during your time here, and what do you feel most frustrated about?
I'm very proud of the project on business combinations. Restructuring the international accounting system into the new IASB is something I'm pleased with as well. Also, working to develop a better understanding in Congress of FASB: what it does, its role, how it fits into the capital market system. But I would like to have made more progress on the issues of timeliness and organization.
What are your plans after leaving FASB?
I am going to work again--for my wife. Seriously, my plans are to move to Arizona and retire. I tried it five years ago. I'm ready to be more successful this time.
Off the Hot Seat
Major rule-making issues that were confronted during Jenkins's term.
- 1982 Business consolidations project is put on the board's agenda.
- 1986 Derivatives reporting (FAS 133) is put on the agenda.
- 1987 Dennis Beresford becomes FASB chairman.
- 1993 Segment reporting (FAS 131) is put on the agenda.
- 1995 FAS 123 increases reporting for stock-based employee compensation plans.
- 1995 Exposure draft is issued for rule on consolidation of minority-owned entities.
- 1996 Accounting for business combinations (FAS 141,142) is put on the agenda.
- 1997 FAS 131 requires more-detailed segment reporting.
- 1997 Edmund Jenkins, after 38 years at Arthur Andersen, becomes FASB chairman.
- 1998 FAS 133 requires new reporting for derivatives.
- 1999 Exposure draft on consolidation of minority-owned entities is revised; references are added regarding SPEs.
- 2001 (January) Exposure draft on consolidation of minority-owned entities is suspended, although focus on SPEs continues.
- 2001 (July) FAS 141 and 142 change business-combination accounting by eliminating pooling and establishing new rules for the valuation of goodwill.
- 2001 (October) Enron's questionable use of SPEs is first disclosed.
- 2001 (December) Board accelerates review of SPE policy.
- 2002 (June) Jenkins will retire from the board.