From the September 2006 issue of Wealth Manager Web • Subscribe!

September 1, 2006

Herding Instinct

Why should advisors--and their clients--care about the workings of the Financial Accounting Standards Board? Howard Silverblatt, senior index analyst at Standard & Poor's, compares the FASB to another influential body--the Internal Revenue Service. "You may not understand the IRS or how it works," he says. "But you have to live by their rules." In the case of the FASB, the board's pronouncements can affect not just what shows up on a company's financial statements, but also its key strategies. "The FASB sets the rules that will affect a company's earnings and balance sheet as well as its bookkeeping and accounting processes," Silverblatt says. "As a result, they literally affect corporate decision making."

What's It All About?

On the surface, the output of the FASB appears to be fairly arcane. The board is a private-sector, independent organization created in 1973 to take over the work of the Accounting Principles Board, which had previously set corporate accounting and financial reporting standards. FASB standards form the core of what are known as generally accepted accounting principles (GAAP), which stipulate the rules for corporate financial reports. Although it is not a government agency, the FASB's authority to set accounting standards is recognized by the Securities and Exchange Commission, and the landmark Sarbanes-Oxley Act of 2002 provided for independent funding for the FASB. Since the SEC requires publicly traded companies to follow the GAAP set by the FASB, the companies in which your clients invest must comply with the rules the FASB lays down.

The board is made of up seven full-time members who have accounting, finance and business expertise gained in corporations, CPA firms or academia. It is currently chaired by Robert Herz, a former PricewaterhouseCoopers partner. The board has published more than 150 statements of financial accounting standards on subjects that include accounting for earnings per share, income taxes, inventories, mergers and acquisitions, stock options and derivatives. It also publishes a host of other guidance, including broad concept statements, interpretations of existing standards and consensuses on dealing with emerging accounting issues. Most of its pronouncements are first published as proposals called exposure drafts. The board solicits comments on these proposals, which it then considers in its final decision making.

"The FASB's mission is to develop accounting rules that provide reliable and relevant information to financial statement users," says Terry Warfield, associate professor of accounting at the University of Wisconsin. "Anybody who is an investor has to base their decisions on information, and usually that includes accounting information." The existence of one set of standards for how and when companies report and record their activities ensures at least basic consistency that makes it easier to analyze a company's results and compare them with those of other organizations, he notes.

In fact, the corporate scandals of recent years underscored the need for strong and rigorous standards, Warfield says, pointing to the Enron debacle as one example of what happens in the absence of thorough accounting tenets. "Enron used the gaps in some of the rules to keep things off the balance sheet that would have shown they had large losses," he says.

But while accounting and reporting standards may be necessary, the FASB's decisions are not always popular. Two FASB projects in recent years illustrate what's at stake and why the board's decisions can cause controversy.

Accounting for Options

The way a company values some of its costs is one critical decision in financial reporting. The lengthy battle over accounting for stock options is an excellent example of why the stakes can be so high. Stock options have been a popular, seemingly inexpensive form of compensation used frequently in industries such as the high-tech sector. In fact, in 2004, a Rutgers University study found that 57 percent of computer services industry workers held stock options, as did 43 percent of those in the communications industry.

In a 2004 revision of an earlier standard, the FASB required that companies use the fair value method to account for this equity compensation. Because the businesses that issue them would now have to recognize stock options on their income statements, this change essentially made stock options a costlier prospect. When the FASB first proposed changing the accounting for stock options in the 1990s, the outcry was so great that the board ended by encouraging voluntary change rather than requiring it. However, the political winds altered after the corporate scandals and the ensuing outrage over executive compensation. FASB Chair Herz told Congress in 2004 that problems in accounting for equity-based compensation had raised concerns among creditors, individual and institutional investors, pension funds, mutual funds and financial analysts. Warren Buffett, writing about the pending FASB stock option proposal in a 2002 Washington Post editorial, asked: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

After the FASB issued its latest standard, the number of option shares granted fell by 12 percent in the first half of 2006, on top of the 18 percent drop in 2005, according to a study by Towers Perrin. Companies seem to have found new forms of compensation, including restricted stock, which may vest based on the number of years an executive remains with a company or on set performance objectives.

Some critics remain unhappy with the FASB standard. "We are concerned about the impact that the rules will have on hiring and retention of key engineering employees," says Anne Craib, director of international trade and governmental affairs at the Semiconductor Industry Association, which was a vocal opponent when the standard was first proposed. Different practices in Taiwan and China mean, for example, employees there "get a far different level of economic benefits from equity-based compensation, and it's a lot more expensive for a U.S.-based company to offer employees options," she says. Warfield, however, is more optimistic. One of the criticisms of the wide use of stock options in the last decade was that they encouraged executives to focus on short-term results. The long-term incentives associated with restricted stocks will make executives think more like shareholders, he says, and future income statements will offer a more realistic picture of company obligations. And in a report issued by the accounting and consulting firm Deloitte, the standard is described as a "golden opportunity" for businesses, because in vying for executive talent, it "shifts the battle for competitive advantage from minimizing the cost of equity incentives to maximizing the gains they can drive." Thus, while the FASB standard may not have an immediate impact on stock prices, behind the scenes it may change some of the ways companies do business.

A Controversy on the Horizon

While the stock option pronouncement created tremendous controversy, looming just ahead is another proposed FASB standard of potentially even greater magnitude. This one tackles how companies should account for defined benefit pension plans and other post-retirement benefits such as healthcare costs. Presently, companies generally disclose information about their pension funding and obligations in a footnote, including details on whether a plan is over- or underfunded. Financial statement users can see the information, but the net number is not added to or subtracted from company earnings or assets. The FASB--in the first phase of its pensions project due to be completed by year end---is proposing to include the number in financial statements. Thus, if a company has a pension surplus--or deficit--of $1 billion, "they would have to take that number and put it on the balance sheet," says Silverblatt. As Warfield puts it, companies will have to "'fess up about the promises they have made to employees." The proposal comes in the wake of pension defaults at companies such as United Airlines, and as congress attempts to address pension reform. The government's pension guarantor--the Pension Benefit Guaranty Corporation--has reported its own $22.8 billion deficit and said it estimates that the defined benefit pensions it insures are underfunded by $450 billion.

In light of the FASB proposal, Silverblatt says businesses are already considering how to curb retirement benefits. "We're seeing companies attempting to limit their future exposure and responsibility," he says, in some cases capping how much they'll chip in for future health insurance cost increases, leaving the balance for employees to cover. Because there are generally no laws or contracts forcing companies to cover non-union workers, "a company can just decide there will be no more post-retirement medical benefits," Silverblatt says.

If companies do freeze or strictly limit the benefits they offer, "It will be an enormous change," he notes, with retirees suddenly forced to take on much more responsibility for their healthcare costs.

In the second phase of the FASB pension project, the board will set rules on how to value retirement benefit obligations and costs--another area ripe for disagreement. The potential political and social impact of pension issues is so great that Silverblatt believes it could affect the 2008 presidential election: People will begin to ask how politicians will address vanishing corporate retirement healthcare benefits for an aging and longer-living population. While decisions about stock options affected management only, changes in pensions would have an impact on all workers, he adds.

Despite this expected turmoil, the upshot for investors may not be all bad. By reacting to the FASB standard, "Companies are doing what they're expected to do," Silverblatt says. "As the corporate owner, they look at the impact and see that they will have to cut benefits. Most companies will see what their competitors are doing and follow suit." From Warfield's point of view, the standard forces companies to face reality. "It's better for investors to have this information now than for companies to make promises now and fail to meet them later," he says.

The Global View

Finally, as the marketplace has become more global, so has the FASB. While many companies subject to FASB rules probably do business in international markets, foreign accounting rules and United States GAAP often are not identical--making it tougher for clients to judge financial statements when considering a range of domestic and overseas investment options. In 2002, the FASB and its global counterpart, the International Accounting Standards Board, formally agreed to embark on an effort to make their standards more compatible.

"This will provide a more level playing field in terms of information," says Warfield. "In the United States, when you pick up an annual report of any company, you can compare the numbers across companies. Right now, though, there are a number of differences between U.S. and international standards."

While that sounds like a step in the right direction, investors should not assume that meeting some of the same standards will mean equal levels of reliability. "In a company, quality is not just a function of the accounting rules; it's also determined by things such as the board of directors' oversight of the accounting function and of the external auditor," Warfield notes. In addition to any FASB rules, publicly traded U.S. companies must meet, among other standards, rigorous Securities and Exchange Commission rules and comply with U.S. laws such as the Sarbanes-Oxley Act. Investors should be aware that the financial information from companies that are not registered with the SEC may not necessarily be as reliable as data from U.S. companies even if the foreign business complies with similar or identical accounting rules, Warfield says.

Keeping up-to-speed

FASB publications can be extremely technical, making it difficult to judge the impact of any given standard. "There might be an enormous publication that really doesn't cause much change, or there may be three words in a standard that change the whole world," Silverblatt observes. For advisors who want to remain current with board activities, the FASB Web site (www.fasb.org) provides a wide range of information about recent decisions and ongoing projects. In addition to the short news items on the main page, the weekly FASB Action Alert (http://www.fasb.org/action/) offers updates on coming board meetings and education sessions and describes recent board decisions in language laymen can generally understand.

Focusing on Private Companies

FASB rules clearly can affect the companies in which clients invest. However, advisors should also be aware of the impact that the FASB can have on small-business owners and other entrepreneurs.

In most cases, only publicly traded companies are required to follow the generally accepted accounting principles (GAAP) set by the FASB. However, that doesn't mean that small, privately owned businesses can simply ignore FASB requirements. Many in the business world believe that GAAP is a kind of gold standard in financial reporting, so they expect companies' financial statements to be GAAP compliant, even if a business isn't technically required to do so. For example:

o Banks, venture capitalists or merger partners may insist on GAAP financial statements before they provide financing.

o State or local regulations may require GAAP financial statements for licensing or other legal compliance.

However, many small private companies find themselves sagging under the weight of requirements originally intended to provide transparent financial reporting for multinational corporations.

Another issue is the difference in the users of the financial statements for private versus public companies. At large corporations, users are typically shareholders who have no day-to-day contact with company management and analysts and financiers who are well trained to understand arcane disclosures and measurements. For these users, detailed financial statements clearly make sense. At private companies, however, the major shareholders often are the company executives themselves, and there is less urgency about offering full disclosure in the financial statements when the people reading them are the ones who actually run the business. Critics also argue that financing for small businesses often is provided by a local banker, who learns more about the company from personal first-hand knowledge of the business in the community than from complex details in the financial statements. "Identical GAAP standards for private and public companies just don't make sense," says William J. Dennis Jr., senior research fellow at the National Federation of Independent Business.

In the past, many have called for separate standards--sometimes referred to as "Little GAAP" --for private businesses, But the effort has languished, in part because of concerns that such standards might be taken less seriously than requirements for public companies--or "Big GAAP." However, the corporate accounting scandals earlier in the decade that led to passage of the Sarbanes-Oxley Act brought forth a variety of tough new rules intended to protect investors--but not always seen as relevant to private companies. As a result, there has been renewed discussion of the need for different financial reporting requirements for public and private companies.

Recently, the FASB and the American Institute of CPAs issued a joint proposal with suggestions on improving financial reporting for private companies. One recommendation is that the two organizations sponsor a joint 12-person committee made up of auditors, company financial executives and financial statement users that would offer the FASB opinions and suggestions on proposed and existing requirements from a private company perspective. Comments on the proposal were due during the summer. The upshot could be changes in what private companies would have to show on their financial statements and how various transactions could be reported. Advisors will likely want to follow developments in this area to alert small-business-owner clients to the potential impact on their companies. More information can be found at www.pcfr.org.--AD

Anita Dennis is a freelance writer specializing in business and finance. She wrote about charitable planning strategies in the May 2006 issue of Wealth Manager.

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