FASB: Rewriting the Book on Bookkeeping

Will broader, simpler rules prevent future Enrons?

In the memos that have poured out of federal investigations, the tug-of-war between Arthur Andersen LLP and Enron Corp. is clear. Time after time, Enron would seek creative accounting for some joint venture or special-purpose entity. Some Andersen accountants would resist, arguing in many cases that the deal didn't serve any legitimate business purpose: "In effect, nothing was accomplished in this transaction but a sale of future revenues," Andersen partner Carl E. Bass wrote in a Mar. 4, 2001, e-mail.

But the bottom line was always clear: If Andersen couldn't show Enron a specific rule prohibiting what it wanted to do, Enron would do it.

Now, the mandarins who write accounting rules want to change that dynamic. The idea: slash the 100,000-plus pages of rules that define "generally accepted accounting principles" in favor of broader, simpler statements of what accountants are supposed to look for when they review, say, a lease or a hedging transaction.

Advocates--led by Securities & Exchange Commission Chairman Harvey L. Pitt--say a return to simpler standards will paint a clearer picture for investors. The move will allow auditors to focus on whether the bookkeeping for a deal makes good business sense. It also will put the burden on corporate clients to prove that their aggressive accounting meets the standard. "What we've got now," says Robert K. Herdman, the SEC's chief accountant, "invites Wall Street and others to create transactions that dot every `i' and cross every `t,' but violate the intent of the rules and fuzz up what's really going on."

The task of overhauling accounting's rulebook falls to Robert H. Herz, a PricewaterhouseCoopers partner who has just been appointed chairman of the Financial Accounting Standards Board. Herz figures the streamlined approach will speed up FASB's tortoise-like deliberations--such as the 20 years it has spent pondering Enron-style special-purpose entities. Eliminating what Pitt calls "check-the-box accounting" will also put the U.S. more in sync with the rest of the world, where International Accounting Standards that rely far more on principles are rapidly being adopted. The result could be the best of both worlds: Streamlined accounting for the U.S. and a sharp improvement in the meager corporate disclosures common in much of the world.

Even with Pitt's backing, Herz faces an uphill battle. The thickets of rules grew up because companies and auditors want bright lines to tell them what sort of bookkeeping will pass muster with regulators--especially the SEC. Shareholders' lawyers reinforce the demand for precision because companies and accounting firms fear they'll be sued for their independent decisions if earnings are off. Company CFOs "have asked for a lot of this [complexity] because we want absolute double-layered protections against being second-guessed," says Philip D. Ameen, comptroller at General Electric Co.

It doesn't help that Corporate America often wants exceptions to broad accounting principles. Critics say FASB's nitpicking hit bottom with Financial Accounting Standard No. 133, which governs accounting for financial derivatives and hedging. Launched in 1992, the standard is based on a simple principle: Futures, swaps, options, and other derivatives should be carried on books at their market value. But revaluing derivatives every quarter can create wide and unpredictable swings in corporate earnings. To avoid that, FASB carved out exceptions for hedging deals, forward contracts for materials, insurance policies, and other special cases. "The exceptions are legitimate," says FASB member John M. "Neel" Foster, "but once you start down that path, it's hard to stop." The result: FAS 133 and its supporting documents weigh in at 800 pages--and it's still a work in progress.

Herz hopes to simplify things. One rush project: close the loopholes Enron used for its special-purpose entities (SPEs). Enron was easily able to move losing investments and hefty debts into SPEs--partnerships controlled by its own executives--because a narrow rule required outsiders to put up only 3% of an SPE's capital. The new proposal, expected by the end of May, generally will require that outsiders provide at least 10% of an SPE's capital--but "10% will not be a bright-line test," says FASB member Edward W. Trott. Instead, the new rule will require that an SPE prove it's truly independent of its sponsoring company.

To institute broader reforms, "we'll all have to step up to the plate," says Herz. "Companies will have to show the real substance of their business, auditors will have to stand tall, and the SEC will have to stop second-guessing." For now, Herz will concentrate on streamlining FASB's upcoming rules on revenue recognition and financial instruments.

Unwriting the complex rules already on the books poses a bigger challenge. "It's almost necessary to start over," says GE's Ameen. But, he adds, "the opportunity to do that may come from the International Accounting Standards."

The global rules take a more broad-brush approach--just as Pitt and Herz want in GAAP. U.S. accountants and regulators have long derided the decades-old process of writing a single international handbook for financial reporting. In trying to merge different approaches, the global rules permitted so many options that they could hardly be called standards. But that's changing, as the London-based International Accounting Standards Board eliminates many choices. The new IASB standard on inventories, for example, will be stricter than U.S. rules.

American GAAP may still provide better disclosure for investors, but Enron makes that argument harder to swallow. "There's plenty of room for both sides to give," says the SEC's Herdman. "We should be aiming for convergence" between U.S. and global standards by 2005, he says.

Changes won't come easily. The legions of lawyers swarming over the remains of Enron and Andersen certainly don't offer much encouragement for CFOs and their auditors to take on more risk in deciding how to get their books right. Wiping out Enron's I-dare-you-to-stop-me approach will require more than a rewrite of the accounting rules--but it's a good place to start.

By Mike McNamee in Washington, with Kerry Capell in London

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