As the Chairman of the Financial Accounting Standards Board, or FASB, from 2002 to 2010, Robert Herz has had a much larger influence on financial markets than the average investor appreciates. FASB is the officially recognized standard setter in the U.S. for financial accounting and reporting standards and the organization that defines U.S. Generally Accepted Accounting Principles for publicly traded companies, private companies and not-for-profit entities.
During his time as the Chairman of FASB, Herz oversaw the creation of standards for expensing employee stock options, efforts to converge U.S. accounting standards with international standards, and providing guidance on fair value accounting for financial instruments in the wake of the 2008 financial crisis.
Earlier this year, Herz released a book about his life and time at FASB, titled Accounting Changes: Chronicles of Convergence, Crisis, and Complexity in Financial Reporting. The book covers Herz’s early life, the major events during his time at FASB, and his views on the overall direction of FASB and the future of financial reporting in the U.S. The book is a must-read for those who are interested in understanding financial reporting and the process of setting accounting standards.
New Constructs takes a keen interest in the rules governing financial reporting so I reached out to Mr. Herz to do an interview for the blog about his book and the state of financial reporting in the U.S. New Constructs’ Financial Journalist Sam McBride also took part in the interview. Below are some of the most interesting excerpts from the 45 minute long interview:
David Trainer (DT): After the last bubble I met with the Senate Banking Committee, Senator Corker and the SEC, and I was trying to very simply suggest that the reliance or the preponderance of attention on the reported accounting earnings wasn’t necessarily the best way to lead investors to make investment decisions, and that a more comprehensive approach would be appropriate, and I got a lot of traction—but what I found is that I was sort of one voice among a million and 990,000 of those other million were the bigger financial firms. And as we’ve seen Wall St. decrease in size we’ve seen lobbying firms in D.C. increase in size. And I’m wondering what kind of perspective you might have on the influence the financial industry or Wall St. has on FASB.
Robert Herz: I’m not sure they have any more influence on FASB than other stakeholder groups, other industry groups. It really tends to depend on the projects that the FASB is working on and the proposed standards they’re working on. Right now leasing’s getting a lot of attention from the equipment leasing industry and from people who are lessees of big ticket equipment because the proposed standard would change the accounting there significantly and alter the look of their financial statements.
I think that in trying to construct instructor and user groups, like the User Advisory Council and the ITAC, we tried to get a broad range of knowledgeable users. Some of them were from Wall St. firms but many of them, like you, were not. So I think it’s that kind of diversity of perspective and interest that is real important.
I would say to you in empathy with your point: I’m not a big fan of earnings multiples, of P/E multiples and things like that. We have made over time dramatic changes in the accounting that affect the denominator of the P/E ratio, but it’s not clear whether and how that flows through the valuations. You think it would. Well maybe they’re smart enough to say ‘I don’t think that ought to’ but I’m not sure. I’m not sure how many users—there’s clearly some like you that are able to understand and dissect the information and rearrange it—but I’m not sure how many are able to do that.
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DT: One of the things that came up during my last ITAC [Investor Advisory Committee) meeting was the complexity of the filings. My feeling is that to the extent that the companies engage in complex activities, it’s their responsibility to, as you say, report on them as accurately or as much as needed to properly portray the underlying economics… What’s your take on the choice between additional complexity and the burden it might have on preparers?
RH: I’m very much a subscriber to the distinction between what’s avoidable complexity in reporting versus what is unavoidable complexity. When you have complicated transactions, trying to dumb down the accounting and disclosure is not the answer. Again, trying to provide the right information and description in accounting—and by it’s nature if you dumb it down you’re not providing the right information. On the other hand you don’t want to create accounting methods—and there are some—that, in my view, particularly get away from basic economic and finance concepts that create additional complexity beyond the underlying complexity of the transactions and arrangements. You want to try to avoid that too.
The other thing about disclosure, per se, to me is, you want to have meaningful, clear, accurate disclosure. But I don’t necessarily subscribe to the phrase ‘disclosure overload’ per se. It may mean that some of the existing disclosure is not particularly useful or relevant, but I’m a big believer that the power of technology can deal with some of those things. There are some people who don’t want to deep dive into all sorts of details… and go down various levels, and there’s others that do, and there’s technology that can deal with that.
DT: …We agree completely on the technology front. That’s what I’ve been building for 10 years is technology to go through these filings, having gone through it manually for as long as I did…it became clear in the late 90’s that it’s not a process that people can really do manually anymore, or do manually with any scale.
RH: No, but I think, whether it’s XBRL or other technologies, we have the ability to be able to perform proper analysis if you want to.
DT: …We feel we’ve created essentially our own version of XBRL going back to when filings were first put into electronic form, and we did it in what I believe to be—and of course this argument’s not that easily defensible—but what I believe to be an economic perspective, or arranging the accounting data in a way that best represents the underlying economics, and doing that consistently across all companies. I feel like that’s where we need to be, and I don’t really know how to get there. Any thoughts on that? And when I say “we need to be” I mean the FASB or the SEC…
RH: There’s several ways it possibly could get there. One is that your type of thinking and approach gets broader uptake in the market, it starts to evolve from the market, and so it really starts to in a significant way drive investment analysis and capital allocation. That’s, to me, often the most desirable way for things to happen.
The other way, of course, is for the official bodies, the SEC, the FASB, the IASB, to, as part of their charge, to move things in that direction. Since I happen to be sympathetic with a lot of what you’re saying, during my tenure as chairman I think we tried to move things that way…
The challenge with that, though, the necessary challenge, is that you have to have sound and thorough due process, and have to be seen to be doing proper cost-benefit analyses and the like. It comes over time I think by a combination of those kind of forces.
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Sam McBride: Getting back to something you talked about earlier in this interview and also in the book, the idea of principles versus more rules based accounting standards. If the U.S. started to move more towards that principles based accounting, how do you think that would affect the regulation and interpretation of financial accounting, and how would it affect the viability of the system we’ve just been talking about.
RH: Well… beauty’s in the eye of the beholder, and I happen to be more in favor of, I won’t use principles based, but I will use the term either objectives-oriented or outcomes-based types of standards that have clearer objectives, that those clearer objectives are linked to underlying economic and finance concepts, and those are then explained with educational examples of how to get there. But then stop there, you don’t have to then go further and say “in this situation do step 1, step 2, step 3” or “you can only do it if the following five things are satisfied.” I find that tends to, in the end, partly undermine the principle or objective, and secondly for those who want to get around it they find ways to be able to structure.
So I favor more objectives-oriented or outcomes-based standards, with enough explanation and education so you can then understand how to apply it and leave it up to people’s judgments without having to write prescriptive rules and guides on every possible thing you can think of.
Then the review and enforcement system has to be one that looks at the resulting reporting and asks did the outcome coincide with what was intended or not, was it reasonable? One of the things I continually emphasize in the book is that in order to get to that kind of system we do need, first a better conceptual framework for accounting. There’s a lot of areas for improvement, which I talk about in the book. And then, secondly, we probably need some institutional, cultural, educational changes in our system around financial reporting. Not easy to achieve because each system has its own inertia.
We have in the U.S. arguably the best financial reporting system in the world because we’ve got lots of disclosure and also because there is also a lot of review and enforcement. But the flip side of that is that it can also discourage improvement and innovation and up the cost of that, as well as discourage people from trying to make sound judgments.
Summary
What a great talk with a man who has seen just about all there is to see when it comes to accounting scandals, financial bubbles, and Wall Street attempts to influence. I highly recommend his book for those who found Mr. Herz’s comments here interesting.
Sam and I are really pleased to hear Mr. Herz focus on the importance of accounting portraying the underlying economics of businesses so investors can make informed decisions. Those words are music to our ears as they articulate exactly what New Constructs research does for its clients.
In my brief experience as part of FASB’s Investor Advisory Committee, I can vouch for the merits and efficacy of the changes Mr. Herz led to bring more feedback and viewpoints into FASB’s decision-making processes. I was very impressed by the intelligence, experience and accounting expertise in that meeting. I believe the opening up the FASB’s decision making process to outside constituents enables better decisions about how to change or evolve accounting rules. And that is a very good thing.