Strategy & Operations » Governance » Accounting: Tides of change

One of the time honoured complaints about financial
reporting is the increase in complexity and the related decrease in
transparency. While many have noted that those twin evils undermine the
usefulness of financial information to capital markets, doing anything about it
seems about as likely as turning back the tide.

But Bob Hertz, chairman of the US Financial Accounting Standards Board
(FASB), has decided to take on the role of King Canute. He is calling for
structural, institutional, cultural and behavioural changes to the system of
financial reporting. The truth is that the detail and volume of accounting,
auditing and reporting undermines the quality and transparency of financial
reporting that it was designed to support.

Standard-setters now see that the current system has engendered a check-box,
form-over-substance approach to accounting, auditing and reporting by financial
directors, auditors and regulators. Professionalism and judgement have gradually
drained away leaving financial reporting to the technical expert, ensuring
minute compliance. The retreat of professionalism and the reliance on detailed
rules increases the opportunity to structure form-over-substance arrangements in
a bid to get the accounting answer you want. This approach also leads to
ignorance and genuine confusion among those producing financial reports.

The US has seen a number of financial reporting restatements. While some are
due to fraud and lack of due care, many reflect unintentional mistakes in
implementing and auditing complex accounting and reporting requirements.
Financial directors face two types of complexity: “what to do” and “how to”. It
is no longer simple to work out which standards, rules or regulations apply in a
particular circumstance, and even when you’ve decided that, there is still the
problem of finding the answer. Increasingly, reporting is relying on accounting
estimates and fair measurements which, in turn, rely on complex data gathering
and processing exercises.

Investors are increasingly unclear about what was done in preparing the
financial statements and to what extent various treatments properly reflect the
underlying business and economic realities.

This complexity arose for many reasons. Financial reporting is a mirror held
up to business; the transactions are becoming more sophisticated and so the
accounting reflects that. But it is more than that. Complexity has arisen as a
result of conflicting perspectives and agendas of those involved in the
reporting process, resistance to change, outdated legacy accounting standards,
an approach to standard setting that produces compromises, exceptions, quick
fixes and inconsistencies. The system is the rope in a tug of war between
politicians, regulators and the profession. All three have shown themselves
capable of putting self-interest above the greater good.

There is also the cultural aspect. We might all say that we want to be
allowed to exercise judgement, but when faced with the threat of that judgement
being challenged by a regulator, or a court, or even a disapproving audit
committee then the temptation is to reach for the comfort of a rule set out in
black and white.

What does reduced complexity look like? For users it could mean more
financial reporting that is relevant, understandable and faithful to the
underlying business it is representing. Some see fair value accounting as a way
to achieve those goals. As the International Accounting Standards Board (IASB)
has recently reaffirmed, it and FASB are looking at fair values as a key way to
improve measurement. But others believe it introduces unacceptable subjectivity,
misleading volatility and additional complexity. In other words, what may be
better for users would not simplify life for FDs and auditors. We could all
produce accounting rules that were simple for FDs to adhere to and easy to
audit, but would convey nothing.

Some suggest that the holistic general purpose financial statement has had
its day. In its stead the future of financial reporting lies in technologies
such as XRBL driving information tailored to the needs of individual users at
that time. Others are still calling for an expansion of the role of the
reporting model to systematically cover non-financial performance indicators,
risk and rewards and forward looking information, while others crave for a
retreat from information and disclosure overload.

It is no accident that Hertz is starting a “cut complexity” bandwagon at this
time. If US GAAP is to merge with international GAAP it would be better if
fit-for-purpose systems came together instead of two which were based on a 19th
century capitalist system, rather than the realities of the 21st century
globalised economy. The fact that there is a call for such fundamental reforms
to the financial reporting system is hugely encouraging. Others, especially the
European Union, need to participate. Hertz calls the status quo neither
acceptable nor sustainable. But how progress will be made and how long it will
take is unknown.