Accounting for Complex Financial Structures

According to a Bureau of National Affairs report, complexity in accounting principals and practices is one of the top challenges to accounting professionals and businesses. The knowledge economy and global marketplace have spawned larger, more diverse, and more complex organizations. Accounting standards and practices have increased in complexity in proportion to the organizations for which they are written. The Financial Accounting Standards Board (FASB) in the United States is the organization that is primarily responsible for writing accounting standards for both public and private companies in the United States. The FASB maintains Generally Accepted Accounting Principals (GAAP) for use by public and private businesses to prepare their financial statements. The FASB has been criticized by various stakeholders for adding to the complexity of accounting standards in the United States. The FASB has been working on an internal codification project that will reorganize GAAP into a much more user-friendly and accessible format. The FASB is also working with other American boards and entities to reduce redundancy in the writing and interpretation of accounting principals. The FASB and the Securities and Exchange Commission (SEC) teamed up in 2007 to address the issue of complexity in accounting and financial reporting and are addressing major issues that have been raised by stakeholders in the public and private sectors. International Financial Reporting Standards (IFRS’s) are being converged with U.S. GAAP standards to eliminate the need for two different sets of accounting standards in the United States. The topics covered in this article highlight some of the challenges that complex accounting practices are posing to public and private businesses in the United States. This article also highlights a number of steps that are being taken to reduce complexity in accounting for complex organizations.

Keywords Accounting Complexity; Convergence with U.S. GAAP; FASB Codification Project; Financial Restatements; International Financial Reporting Standards (IFRS)

Accounting > Accounting for Complex Financial Structures

Overview

The topic of complexity as related to accounting is like the chicken-or-the-egg scenario. Is complexity related to accounting as the result of the complexity of today's organizational structure, or have the rules just become more complicated in an effort to account for complex organizations? The answer to this question lies somewhere in the middle. Certainly the nature of American corporations has changed rapidly and radically over the years, and accounting rules have struggled to keep up. The following comments were made in 2006 by then SEC commissioner Cynthia Glassman.

The comments by Commissioner Glassman indicate that accounting rules are being written in response to the changing nature of American and global business.

According to the Bureau of National Affairs' (BNA) Accounting Policy & Practice Series(tm), "The advisory board members—high level corporate accountants from Corning, Microsoft, and Eli Lilly and Co., as well leading academics and advisors —named complexity as a key topic when asked to name top [accounting] issues for 2007" ("Surviving Complexity," 2007). This article focuses on the complexity of today's accounting standards and how organizations are responding to the myriad changes that affect their financial and accounting practices.

The following comments underscore just how big the issue of complexity is for those who must interpret accounting rules in today's economy. The comments were delivered to the FASB and the SEC by a committee from Financial Executives International (FEI).

• Every effort should be made to work with stakeholders "to end the proliferation of detailed rules"; the general consensus from FEI and its subcommittee, the Committee on Corporate Reporting (CCR), is that accountants are struggling to understand and keep up with the deluge of new accounting standards.
• "Over the past ten years, the Board (FASB) has issued a significant number of standards that are among the most complex we have ever encountered. These standards have caused significant difficulties in practice due to one or more of the following: Scopes that are broad and hard to comprehend; complex accounting principles that require extensive supplemental interpretive guidance; and measurement principles that presume a level of valuation capabilities that do not exist uniformly across the preparer community" (Difabio, 2007).

Globalization, the rise of multinational corporations, compliance, government oversight, and mergers and acquisitions have greatly impacted accounting practices at public companies. "Accountants, investment bankers, and clients are structuring financial instruments around the provisions of highly technical, complex accounting pronouncements. The game is based on whether the security falls either inside or outside of the established principle. The predictable recipe resulting from this cookbook is what one observes in Enron, WorldCom, Adelphia, and so on" (McCarthy, 2004).

Currently, regulatory and financial reporting is much more demanding for public companies than for private companies—as are the stakeholders who have the most invested in sound accounting practices and accurate reporting of company financials. Common stakeholders for public and private companies include employees, customers, partners, and boards of directors. Private companies' biggest stakeholders are company owners and banks and institutions that finance the company's growth. Public companies' stakeholders include executive managers, investors, and creditors.

Private Companies

Private companies, while not subject to the same government oversight as public companies, are faced with increasingly complex accounting rules as well. GAAP for public companies are increasingly diverging from the GAAP standards for private companies.

In reference to the proliferation of complex accounting principals, one critic points out that the FASB is rewriting accounting standards to support publicly traded companies, which constitute the minority of businesses in the United States.

Privately held companies still comprise the vast majority of businesses in the United States, and many are convinced the FASB is rewriting accounting standards to support the minority of businesses (public companies).

To fully understand how and why accounting standards are changing so rapidly, one must also look at the changing nature of American business as it moves steadily to a knowledge-based economy. Many of the standard industrial age accounting practices do not accurately address the changing nature of American and international business. In today's knowledge economy, businesses have fewer tangible, "hard" assets on their balance sheets. More typically, today's corporation derives much of its value from intangible assets such as customer relationships, intellectual property, brand recognition, and other knowledge-based activities.

The shear number and breadth of current accounting standards contributes to the difficulty and complexity for public and private companies to stay on top of current accounting procedures. "The proliferation of codified accounting principles has, in large part, led to the distress that the profession currently is experiencing. Codified principles issued by the Accounting Principles Board (APB), then by FASB, have led to a 'cookbook' approach to financial reporting" (McCarthy, 2004).

Few investors and other stakeholders would disagree that corporations have become complex entities. Many corporations (U.S.-based and others) have operations in many different countries. Operations continue around the clock in different time zones, and many corporations rely on far-flung but highly integrated supply chains. Investment capital is readily available along with a more diverse set of creditors and investors. The vast changes that globalization and the “flattening” of the world have initiated are reflected in the financial and accounting standards that have attempted to keep pace with these changes.

This article investigates the current topic of reducing financial reporting complexity that is being studied by the SEC, FASB, and the U.S. Treasury Department. Topics include

• SEC efforts to study practices that will reduce complexity in the creation and application of accounting principals.
• increasing numbers of financial restatements.
• what information investors and owners really want on financial statements.

This article concludes with a look at the move toward the adoption of IFRS’s, the future role of the FASB, and some of the implications affecting private companies.

Applications

The FASB is the specified private-sector organization that determines financial reporting and accounting standards.

Financial statements should be

• credible.
• concise.
• transparent.
• understandable.
• responsive to a changing economic environment.
• useful to public and others for decision-making.
• promote, whenever possible, convergence with existing standards.

This article investigates different viewpoints regarding just how well stakeholders from public and private companies think the FASB is adhering to its stated core mission and directives.

Public Companies—GAAP

Private companies are largely exempt from many of the prescribed accounting and compliance standards that affect public companies. As accounting standards are revised, many would say with an emphasis on public companies, GAAP standards for public and private companies diverge to a greater extent.

Complexity has become part of the business landscape in the United States when it comes to accounting practices. Officials at the Public Companies Accounting Oversight Board (PCAOB), "acknowledged that, as a result of the enactment of the Sarbanes-Oxley Act, auditing standards for public companies now differ substantially from those of nonpublic companies. The differences are factual and no longer arguable" (McCarthy, 2004).

Private companies greatly outnumber public companies in the United States. Critics of the FASB contend that the board has largely ignored private companies, as many of the recent standards are slanted toward publicly traded companies. "Private companies have a significant impact on our economy, and the attention given to this sector by our standard setters has been largely nonexistent compared to that given to public companies, which represent only a fraction of the 22 million businesses in the United States" (Kranacher, 2006). As FASB accounting standards and GAAP are written for different constituencies—public and private companies—the volume and complexity of standards increase. Private companies are not subject to the same regulatory reporting and financial transparency as public companies, and as such may be erroneously regarded as having a lower bar for financial reporting and for applying GAAP.

"The intention is not for private-company GAAP to be less significant or less prestigious than public-company GAAP. It would be different, that is all. Auditing standards for public companies are not considered superior to those required for nonpublic companies. Neither should private-company accounting principles be considered less significant than those promulgated for multinational companies" (McCarthy, 2004). The future of the FASB is in question— particularly in regard to its role as a standard setter for public companies. As IFRS standards take the place of GAAP standards for public companies, it has been suggested that the FASB may refocus its attention on setting standards for private companies. It remains to be seen if maintaining GAAP alongside IFRS standards will help to reduce accounting complexity for private companies.

Creation of the SEC & Treasury Board Oversight Committees

Early in 2007, it seemed that Congress was finally ready to address the topic of complexity in accounting. This time, the FEI sounded the warning that complexity in accounting standards is likely compromising American market competitiveness. While concerns about increasing complexity in accounting standards had been a topic for some years, in 2005 the FEI filed comment letters with the FASB expressing concerns about FASB statement 141 (Business Combinations). The FEI stated that the "cumulative consequences of these statements leave accountants struggling to understand what to do." According to the FEI (a perennial watchdog of the FASB), the complexity of FASB statements was increasing company reliance on outside subject matter experts to apply requirements. Fast forward to 2007 and the FEI once again voiced concerns about reducing complexity, while concurrently the FASB was working to finalize standards on business combinations and release new or revised statements such as FIN 48 and statement 133 (DiFabio, 2007). In June of 2007, "Washington responded to the crisis by forming a commission to study the problem" (DiFabio, 2007). The SEC chair at the time, Chris Cox, with support from the FASB and the PCAOB, announced the establishment of SEC's Advisory Committee on Improvements to Financial Reporting (CIFR).

"Cox said the SEC-sponsored group will focus on reducing complexity in U.S. financial reporting, while an effort promoted by U.S. Treasury Secretary Henry Paulson will examine the business of U.S. accounting, now dominated by the Big Four accounting firms. Still, Cox didn't rule out potential overlap between the two studies and said the SEC will coordinate closely with Treasury Department officials on the committee's work" (SEC Unveils Effort To Attack U.S. Accounting Complexity, 2007).

The goals outlined by the SEC-sponsored group included the following goals and objectives addressed in 2007-2008 ("Surviving Complexity," Top 2007):

• creating less complex accounting rules and clear direction for companies applying them
• determining better ways to communicate financial results to sophisticated and ordinary investors
• reducing irrelevant financial reporting
• moving toward convergence with international standards
• pushing toward fair value reporting for financial instruments
• continuing the FASB codification project

While the FASB chair did not dispute that accounting standards are overly complex, he was quick to point out the mission of the FASB in creating current standards. Accounting standards are written to meet business needs through accurate application and creation of financial reports (Glassman, 2006).

• Standards allow companies to present their business and financial conditions based on current knowledge and expectations for the future.
• Standards provide accurate reports of companies' operating results and cash flows.
• Financial statements reflect economic and business reality and help investors formulate investment decisions.
• Statements decrease the probability of distorted business reality and cause capital to be deployed suboptimally.
• Standards allow companies to provide investors with accurate information about the value of investing in a given company.
• Standards provide customers and suppliers with accurate data to make important business decisions.
• Standards inform lenders about the true risk associated with loans.
• Standards provide employees with an accurate picture of employer's financials.

Financial complexity can be as devastating to corporate reputation and confidence as fraud (Glassman, 2006).

Codification

The FASB has its eyes on a convergence of American accounting standards with international standards, but first the United States needs to reign and codify its own disperse accounting regulations. According to Glassman, "Accounting standards and literature flow from a vast array of standard setters, regulators and other sources. The financial reporting landscape is littered with pronouncements from the FASB, the AICPA, the EITF, the APB, the SEC and the PCAOB. We have pronouncements, rules, regulations, guides, bulletins, audit standards, interpretations and practice aids in the form of SOPs, FAQs, SABs, Q&As and FSPs" (Glassman, 2006).

Estimates put the number of separate pronouncements that apply to U.S. GAAP at more than two thousand. According to Glassman, the SEC, like many government agencies, has a "bureaucratic tendency to create ever thicker rule books." The standard setters simply add another layer of complexity with each pronouncement until "the original regulatory goal becomes obscured amid thousands of words of detailed dictates. Some SEC rules, intended to guide market participants in daily decisions, have become a kind of Latin liturgy, comprehensible only to those of us who have devoted our professional lives to abstract regulatory nuances" (Glassman, 2006).

Before the United States can even hope to converge U.S. GAAP and other accounting principals with international standards, a huge amount of work needs to be done with the U.S. codification project. "Codification has been cited as a top issue in 2007 and will serve to move toward the development of a uniform set of accounting standards. The standards will be more objective-oriented and principals-based. The codification project will integrate accounting guidance from the FASB, AICPA, EITF, and SEC into a single, consistently written source" (Iannaconi & Schinas, 2007).

Robert Pozen also took a stab at the myriad standards that are inundating companies and their financial preparers. The SEC group blames the complexity build-up on the wealth and length of accounting standards from FASB in the past several years, and on the mounting interpretations of those rules coming from regulators and the accounting firms. “We have too much GAAP running around,” Pozen said during the CIFR’s first meeting. “We need to figure out what is and isn’t GAAP and grab hold of it” (Johnson, 2007).

Financial Restatements

One big concern around complexity in financial and accounting reporting is the increase in financial restatements by companies. A restatement refers to the revision of a company's earlier financial statements. Restatements can result from clerical error, fraud, or through misinterpretation of accounting standards. The increasing number of restatements has been seen by the SEC committee as an indication that the financial reporting system is overly complex (SEC Unveils Effort To Attack U.S. Accounting Complexity, 2007).

Robert Pozen, then chair of the CIFR, stated "We need clearer accounting standards." He also suggested that firms are finding it difficult to comply with accounting rules and added that costly and confusing financial restatements could be improved if American accounting rules “were simpler to understand and apply" (SEC Unveils Effort To Attack U.S. Accounting Complexity, 2007).

Value of Financial Statements

Complexity in accounting standards has led to complexity in financial reporting as well. In general, financial statements are not only difficult to prepare; they are also difficult for many holders to understand. The use of press releases by corporate management is thought to be an indication that many users do not want or need the complex level of information that is provided on many financial statements (Iannaconi & Schinas, 2007). The Governmental Accounting Standards Board has committed to using plain language in its communications with constituents (Governmental Accounting Standards Board, 2013).

Comments provided by constituents to the FASB are being taken seriously. The end result of all the complexity associated with creating accurate and usable financial statements is having the opposite effect for many end users. According to Glassman, "Commentators have suggested that our current prescriptive accounting rules have contributed to a lack of transparency in financial reporting, where boilerplate conceals what is really going on" (Glassman, 2006).

Glassman added, "Reducing accounting complexity and migrating to a more principles-based accounting system would encourage more accurate and complete financial disclosure. Therefore, standard setters and regulators should consider how accounting standards and disclosure rules can be re-designed to elicit information that is complete, clear and concise, and thus, more useful to investors" (Glassman, 2006).

The SEC's CIFR group also examines what type of financial information investors and other stakeholders need and want going forward. The CIFR is aware that companies may be more interested in key performance indicators (KPI) and forward-looking information rather than complex financial statements. According to the CIFR, "Financial performance summaries, compressed into a few pages, might be helpful for individual investors, provided firms include links to supplemental details that are useful to analysts and sophisticated investors" (SEC Unveils Effort To Attack U.S. Accounting Complexity, 2007). This information may be more useful than much of the current information that is provided on financial statements (Iannaconi & Schinas, 2007). The CIFR helps make financial statements more useful and relevant to end-users.

Conclusion

In the third quarter of 2007, the SEC issued a statement that proposed eliminating the requirement of international companies to reconcile their IRFR prepared financial statements with GAAP. Some question if U.S.-domiciled businesses (multinationals) should have a similar choice. Critics of this move state that the SEC is pushing too fast for the adoption of IFRS standards. Related questions are

• what is the future of GAAP?
• how will this move affect the ongoing convergence of GAAP and IFRS standards?
• what will be the role for the FASB going forward if GAAP is eliminated?

There is certainly a suggestion that the FASB will still lose its standing as the official standard setter for the accounting rules that govern American-based public companies. There have been suggestions that the FASB could serve as the new standard setter for private companies and nonprofits in the United States. The FASB could also take on a role in educating companies about the new IFRS standards, or serve in an advisory capacity to the board (Is FASB fading away? 2007).

This proposal is a clear signal that there is an international movement to adopt one strong global accounting standard. The major accounting firms have voiced favor for the SEC proposal and concede not only the inevitability of IFRS adoption, but a speedier time line for adoption. There are numerous concerns about any course of action; some fear that allowing for a dual set of standards (GAAP and IFRS) will slow down the convergence to a global standard. Others feel that the SEC is being hasty in its proposal, as many feel that IFRS standards are not yet ready.

Terms & Concepts

Accounting complexity: Refers to the proliferation of American accounting principals, which have become increasingly bureaucratic, complex, and prolific. In 2007 the SEC established an independent committee to investigate how to address the debilitating issue of accounting complexity for American corporations.

Bureau of National Affairs (BNA): The largest independent information and analysis publisher for tax, law, business, and government professionals.

Business combination: A transaction or other event where one entity takes control of one or more businesses through acquisition. A business combination can occur in a number of situations, but it usually happens through the purchase of the net assets or equity interests of one or more businesses.

Codification Project: See FASB Codification Project.

Convergence with U.S. GAAP: In 2002 the IASB and the FASB agreed to coordinate their agendas to minimize differences between IFRS and U.S. GAAP (the Norwalk Agreement).

Financial Accounting Standards Board (FASB): The the specified private sector organization responsible for determining financial reporting and accounting standards. The FASB is recognized by the SEC as the official setter of accounting standards.

FASB Codification Project: This project organized the thousands of articles in the U.S. GAAP based on accounting topic. All 90 or so topics are presented using a standardized structure (Federal Accounting Standards Board, 2012).

FEI- Financial Executives International: FEI has become the leading advocate for ensuring that corporate financial management voices get heard. Its 15,000 members hold numerous policymaking positions as chief financial officers, treasurers, and controllers. The FEI is a watchdog organization of the FASB.

Financial restatement: Refers to the revision of a company's earlier financial statements. The need for restating financial figures can result from fraudulent practices or the misrepresentation of financial or accounting standards through human error.

Generally Accepted Accounting Principals (GAAP): The standardized structure for financial accounting guidelines. Mainly used in the United States, it includes standards, conventions, and rules followed by accountants while recording and summarizing transactions and preparing financial statements.

Intangible assets: Nonmonetary assets that cannot be physically measured but that are created through time and effort. The two main types of intangibles are legal intangibles—such as trade secrets, copyrights, patents, trademarks, and goodwill—and competitive intangibles—such as knowledge activities, collaboration activities, leverage activities, and structural procedures.

International Financial Reporting Standards (IFRS): Standards and interpretations adopted by the International Accounting Standards Board (IASB).

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Is FASB fading away? (2007). CFO.com. Retrieved November 24, 2007, from http://community.dynamics.com/blogs/financeheadlines/archive/2007/11/13/is-fasb-fading-away.aspx

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Suggested Readings

Business combinations II. (2007). IASB. Retrieved November 18, 2007, from http://www.iasb.org/Current+Projects/IASB+Projects/Business+Combinations/Business+Combinations+II.htm

Johnson, K., & Richson, C. (2007). The global M&A boom continues: Are boards getting shareholders their money's worth? Corporate Governance Advisor, 15, 25-31. Retrieved November 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26765843&site=bsi-live

Massoud, M., & Raiborn, C. (2003). Accounting for goodwill: Are we better off? Review of Business, 24, 26. Retrieved November 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9547955&site=ehost-live

Summary of FASB tentative decisions on business combinations. (2004). FASB. Retrieved November 16, 2007, from http://www.fasb.org/st/summary/stsum141.shtml

Tysiac, K.(2013). New mechanisms eyed by FASB, IASB in long march toward global comparability. Journal of Accountancy (Nov. 2013). Retrieved November 27, 2013, from http://www.journalofaccountancy.com/News/20137119.htm