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The FASB should consider economic consequences in the standard setting process;

“The Board cannot cease to be concerned about the cost-effectiveness of its standards.

To do so would be a dereliction of its duty and a disservice to its constituents”. (SFAC

No.2 P. 144) FASB member Victor H. Brown identified the economic costs to consider:

The costs of introducing a new standard, of course, include the out of pocket costs of converting to the new standard, the costs of processing and reporting

the information required, and possible increases in audit cost…

also include disclosure costs, measured in terms of lost competitive advantage. Even harder to assess are the costs incurred by all parties in attempting to understand, digest, and adapt to new rules. The new rules can have an impact

on existing and prospective contractual relationships, and internal management and organizational adjustments must often be made to understand and relate to new ways of measuring entity performance. External users of financial reports also must adjust to and interpret reported information produced in accordance with the changed standards”.

But costs may

The FASB considers the economic consequences of a standard during the normal

course of its political “due process”. According to FASB’s The Structure of Establishing

Accounting Standards, “The process of setting accounting standards can be described

as democratic because like all rule-making bodies the board’s right to make rules

depends ultimately on the consent of the ruled”. One of the advantages of the process

is that external parties are invited to comment on exposure drafts or present testimony

during roundtable discussions. The history behind SFAS No. 123 provides us with a

prime

example

of

external

parties

influencing

Board

decision

in

order

to

avoid

detrimental economic consequences on reported earnings and finally influencing to

regulate because of the economic consequences. The 1993 Exposure Draft was

extremely controversial and the Board received over 1,700 comment letters objecting to

the recognition of compensation costs for employee share options. The Board held six

days of public hearings and representatives from 73 organizations presented testimony.

Amazingly, legislative proposals addressing this accounting issue were introduced

before Congress both opposing and supporting proposals in the 1993 exposure draft. “A

Sense of the Senate resolution was passed that the FASB should not at this time

change the current generally accepted accounting treatment of stock options and stock

purchase plans”. However, a second resolution was passed stating, “Congress should

not impair the objectivity or integrity of the FASB’s decision making process by

legislating accounting rules”. In light of the extraordinary controversy surrounding the

1993 Exposure Draft, the Board decided to encourage, rather than require, recognition

of compensation cost based on a fair-value-based method and pursued expanded

disclosure instead. Statement 123 was issued in October 1995 and entities continued to

apply the provisions of Opinion 25. Given the serious corporate reporting failures in the

early 21 st century, (ex: Enron), Congress and regulators pushed for a focus on high-

quality

transparent

financial

reporting

and

a

demand

for

entities

to

recognize

compensation costs for employee share options. Numerous entities were voluntarily

choosing to apply the fair-value-based method of accounting however; this raised a

comparability issue across business organizations. The IASB, in 2002, issued an

exposure draft, Share-Based Payment, which proposed a single fair-value-based

method for share-based compensation arrangements. The Board now concluded that

the stipulations of No. 123 needed to be re-evaluated. In 2004, more than 10 years after

the initial exposure draft, the FASB issued SFAS No. 123R requiring the recording of

expense for incentive stock options. Conclusively, external parties will attempt to

influence standard formulation based on the economic consequences of the issue at

hand and clearly, the standard must be “generally accepted” by both the regulated party

and society as a whole despite the economic consequences involved. Assessing and

quantifying these types of behavioral reactions regarding the economic consequences

of a proposed standard will always pose difficulties for the FASB, There is no way of

determining optimal regulatory policies that maximize the social welfare or the public

interest. The best that regulators can do is to try to determine that a net benefit exists-

that is, an excess of benefits over costs.” (Wolk et al p 129)

SFAC No. 8 addresses the cost constraint on useful financial reporting, “Cost is a

pervasive constraint that standard setters, as well as providers and users of financial

information, should keep in mind when considering the benefits of a financial reporting

requirement.(SFAC No. 8 BC 3.47) However, the ability to place a dollar value and

fully enumerate a cost or benefit is almost an impossible task for standard-setters.

Additionally, there is no way to successfully identify and measure all of the economic

consequences associated with a new standard. The FASB should be applauded though

for advancing uniformity in accounting standards, however; uniform financial reporting

suggests a one size fits all approach. “Smaller, non-publicly listed firms (and their

auditors) argue that accounting standards are formulated mainly for larger, publicly

traded firms” and that “compliance costs are disproportionately higher and the benefits

smaller since the firms’ securities are not traded”. (Wolk et al p 127) Therefore, smaller

and medium sized entities remain economically disadvantaged by some standards

despite the cost-constraint acknowledgements of the Board. The IASB however has

recognized the need for small to medium size firms to have separate standards and

have issued a separate International Financial Reporting Standard for Small and

Medium Sized Entities. Interestingly, the FASB and the IASB have been working

together since 2002 to achieve convergence between US GAAP and IFRSs in order to

develop a common set of high-quality compatible accounting standards. “All companies

compete for capital in the world equity markets. To survive and grow, companies have

to have access to the cheapest money available. By migrating to IFRS, many

executives believe they will be better able to attract foreign investment for growth” and

“enable

analysts,

shareholders,

and

company

management

to

evaluate

financial

performance among industry competitors, no matter where they are domiciled around

the globe”. (White, W.C.) Without a doubt, the FASB has considered the economic

consequences and impact of accounting standards on U.S. competitiveness in the

global market place.

According to CON 8, “the objective of general purpose financial reporting is to provide

financial information about the reporting entity that is useful to existing and potential

investors, lenders, and other creditors in making decisions about providing resources to

the

entity.

Those

decisions

involve

buying,

selling,

or

holding

equity

and

debt

instruments and providing or settling loans and other forms of credit.” Since the

objectives of general-purpose financial reports focus on the user, a new standard must

therefore enhance the usefulness of the financial information. However, once again, the

FASB encounters difficulty in measuring the economic consequences pertaining to

usefulness to investors, creditors, managers, labor unions, government regulatory

agencies, suppliers and the general-public’s utilization of the general purpose financial

reports for decision-making. Finally, there is the impact of a new standard on the

preparer of financial information. Managerial accounting has taught us that direct costs

are more easily measured than indirect costs. Preparer direct costs include amounts

associated with the education of staff and management, audit costs, and most

importantly

the

financial

consequences

on

reported

earnings

resulting

from

the

standard, (ex: SFAS 123R). Earnings management would be considered an indirect

cost if a new standard tempted management to behave in a self-serving manner in

order to increase compensation or positively reflect the entity for shareholders. Without

a doubt, the FASB must consider the economic consequences associated with a new

standard. However, allocation of weight between purist and economist is virtually

impossible for the FASB when faced with the apparent measurement and quantification

issues presented in this paper.

The history of

accounting warns us that

when

addressing accounting issues from a purist perspective, economic consequences are

not considered in the decision process, results in standards that are

not

“generally

accepted”. On the other hand, if the FASB decision process relied purely on economic

consequences, standards would be constantly changing based on the dynamics of the

financial

environment

and

would

put

the

integrity

of

financial

reporting

at

risk.

Calculating the weight to attribute to an economic consequence thus remains open. We

must therefore rely on the professional judgment of the bodies entrusted with standard

setting, the FASB, to forward standards that embody the fundamental qualitative

characteristics of relevance and faithful representation and enhance financial report

usefulness for the investor, lender, or creditor in making a decision.

Henry Kissinger said it well when he described governmental policy matters without a

conceptual framework, “Policy makers are forced to respond to parochial interests,

buffeted by pressures, without a fixed compass”. The FASB is our fixed compass.

References:

Statement of Financial Accounting Concepts No. 2 Statement of Financial Accounting Concepts No. 8 Statement of Financial Accounting Standards No. 123R Wolk, H., Dodd, J., & Rozycki, J. (2013). Accounting Theory: Conceptual Issues in a Political and Economic Environment. The LIFO Conundrum: Convergence of US GAAP with IFRS and Its Implications on US Company Competitiveness, by William C. White IV.