Yesterday's accounting scandals are going to produce a lot of today's accounting reforms.
Investors have clamored for change. And now, many of the nagging issues that not long ago looked hopelessly stuck in the status quo — accounting for stock-option compensation, among them — finally seem on the fast track to change. Nowhere has that transformation in attitude been more evident than at the Financial Accounting Standards Board, where proposals that once gathered dust for years in some cases are getting pushed through in mere months.
“Some of the stuff we're seeing as standards in early 2003 evolved in 2002, which is kind of like turbo mode for the FASB,” says Jack Ciesielski, publisher of the Analysts' Accounting Observer newsletter in Baltimore, who recently joined the board's Emerging Issues Task Force.
Here's an update on some high-profile, hot-button issues. Some stem directly from the scandals, others more from the resulting push to wipe out appearances of just about anything that smells of poor earnings quality. To be sure, every wave of financial scandal historically has been followed by a wave of reform, which is then followed by a new wave of scandal that the reform proved ineffective at heading off, followed by more reform. Cheats will be cheats and will find new ways to plump their profits. That said, this year could see some real progress.
Dwindling options for stock options: Finally, it looks as if the accounting-rule makers have summoned the courage to mandate that companies record stock-option compensation as an expense on their income statements, not just in their footnotes. Already, the FASB has required quarterly — instead of merely annual — footnote disclosures of companies' estimated option expenses. And unlike the last time the board tried to go the distance with this proposal back in the mid-1990s, nowadays the politicians don't appear inclined to intervene and risk appearing to be advocates of bad accounting.
To be sure, the usual suspects — namely option-dependent technology companies and the Nasdaq Stock Market, which needs all of the listings it can get these days — recently have turned up their lobbying in a last-ditch effort to preserve the old system of “free” compensation, at least for accounting appearances. Still, the odds they'll stave off the latest push are much worse than before. A proposal for a new standard requiring expensing of options could come this year.
What's fair isn't always fair: If companies are required to expense stock options, this big question looms: How are companies supposed to figure out how much these options are worth? It turns out that Wall Street's vaunted Black-Scholes mathematical model makes options on highly volatile stocks look unduly valuable, even where the stocks have crashed. The estimates fed into these models also reduce the models' reliability.
Of course, companies rarely object when the discretion they're given to make estimates produces extra income, rather than expense. Corporate balance sheets now sport trillions of dollars worth of the financial instruments known as derivatives, many of which are thinly traded and not easy to value accurately. The collapse of the energy traders, led by Enron Corp., exposed an industry whose valuation methodologies too often were optimistic at best, and fraudulent at worst.
As a result, securities regulators and accounting-rule makers say they intend to cast a more skeptical eye on any so-called fair-value techniques, including those for valuing derivatives, that leave too much discretion to companies' management. Expect a lot of hand-wringing on this front in 2003, maybe even some regulatory calls for greater disclosure of valuation methods and assumptions, but not much more than that.
Pensive thinking on pensions: Long ago, the accounting-rule makers came up with complex rules that let executives “smooth” the effects of a pension plan's investment performance over time, to avoid jarring the income statement with short-term market volatility. Too often, critics complain, executives use these smoothing mechanisms to prop up their companies' bottom lines. Need an earnings boost? Then ever so slightly increase the assumed rates of return for the following year, and — poof! — profits look better, even in dismal markets.
That probably won't change soon. Pension accounting isn't on the FASB agenda yet. But the board did signal recently that it is receptive to new proposals. One relatively easy fix would be to improve the frequency and display of information. Some investors are pushing for quarterly, rather than annual, disclosure of pension plans' effects on corporate performance, possibly shown on the income statement itself. The idea has at least a shot of passing this year — if enough investors demand it.
Cookie jars: This is one of the oldest tricks in the book. A company announces a “restructuring” plan, say, for coming layoffs or plant closings. Next, it takes a big charge to earnings — which it advises investors to ignore as a “special” or “one-time” item — to reserve for the costs of executing the plan by setting up liabilities on its balance sheet. Then, lo and behold, the restructuring costs turn out lower than originally forecast, allowing the company to reach into the corporate “cookie jar” and reverse part of the reserves, resulting in a boost to net income.
That game is mostly over, thanks to a new standard passed by the FASB last year. Now when companies make plans to exit from or dispose of a business line, they aren't allowed to set up liabilities to reserve for the future costs. Instead, they must recognize the costs over time as they're actually incurred. Without restructuring reserves, there can be no cookie-jar reserves. Problem solved? Not quite.
As it turns out, the new standard didn't address the accounting for restructuring plans undertaken in connection with a merger or acquisition. So, for the time being, companies still can set up large reserves for acquisition-related restructurings. That option won't be around for long, though. Expect new FASB guidance this year forcing companies to recognize acquisition-related restructuring expenses as they are incurred.
Growing global harmony: Look for more convergence between U.S. and international accounting standards, led by the FASB and the upstart London-based International Accounting Standards Board, in a movement that envisions the financial statements of a company in Germany, for instance, someday being comparable with those of a U.S. rival.
The Securities and Exchange Commission has signaled that it is open to eventually allowing U.S. stock listings of foreign companies that prepare their books under international accounting standards — but only if, among other things, the European Union adopts a uniform set of international standards. In the meantime, foreign issuers with U.S. listings must prepare a second set of books under U.S. principles.
Last year, the FASB and the IASB held their first joint meeting. The two boards have begun identifying areas where divergent U.S. and international standards can be reconciled. The boards also are tailoring new standards to avoid major differences, where feasible. The international board, for instance, has a new draft for merger-and-acquisition accounting that in many respects mirrors rules passed recently in the U.S. And the FASB's plan to soon require expensing of stock-option compensation hinges on the IASB passing its own standard on the subject this year.
These are first steps. Some problems will take years to solve, if they're even solvable — like melding U.S. and international standards for insurance contracts or derivatives. And lately, there have been hiccups. In Europe, objections from France and other countries to the international board's proposals on derivatives accounting prompted the European Union to miss the Dec. 31 deadline it had set to bless a package of about 35 international standards. That missed deadline probably won't be the last, in what promises to be a lengthy process.