Transparency Lite

By Thomas Brom

My, how circumstance tends to alter one's priorities. In late August the SEC voted unanimously to propose for comment a "road map" for convergence with international accounting standards, ushering in a new age of global financial transparency. But the credit crisis intervened, and the SEC hasn't mentioned the road map since. "The whole regulatory apparatus of accounting rules and capital standards--it all becomes irrelevant when the entire financial system needs a government guarantee to hold it up," columnist Holman W. Jenkins Jr. wrote in the Wall Street Journal in October. "That's where we are today."

So just as politicians from all camps are promising increased transparency, companies that issue financial statements are urging the SEC to postpone imposing the very accounting standards that might produce it. Particularly during times of crisis, accounting standards are contested terrain.

In the United States, accounting rules are the purview of the Financial Accounting Standards Board (FASB) in Norwalk, Connecticut. Founded as a private organization in 1973, the FASB is currently supported by mandatory fees assessed on public corporations under reform provisions of the Sarbanes-Oxley Act. The board, selected by members of the parent Financial Accounting Foundation, then submits its standards to the SEC for approval.

According to Paul B. W. Miller, an accounting professor at the University of Colorado, compulsory fees have fostered a more independent FASB board. Previously it had been split between those representing the issuers of financial statements--public corporations--and those representing the users of financial statements--institutional investors and the rest of us. "The interests of issuers and users are perfectly aligned in the natural state," Miller says, "but are put at cross-purposes by managers who think they can control their stock prices by controlling the message in their financial statements."

The credit crisis revived those old divisions, producing disputes this year over proposed changes to standards for hedge fund accounting and the treatment of qualified special-purpose entities. But no revision was more hotly contested than Financial Accounting Standard (FAS) 157, which requires issuers to account for assets, even in illiquid or inactive markets, at current market value rather than historical cost.

Depending on your viewpoint, mark-to-market accounting either precipitated the credit crisis by forcing issuers to write down securities that had no market value, or shined enough light on mortgage-backed securities to enable central banks to prevent systemic collapse. Issuers, of course, faulted the accounting standard. "I have seen loads of petitions from managers--especially bankers and their members of Congress--to stifle the reporting of market values," Miller says, "but none from the people who consume the information."

Sen. Charles Schumer (D-N.Y.) proposed a limited moratorium on fair-value accounting earlier this year. The FASB responded by issuing guidelines that permitted issuers a broad interpretation--and then relaxed the standard further in October. But it wasn't enough. Days later the American Bankers Association asked the SEC to suspend mark-to-market accounting entirely.

Lawyers, too, have been drawn into the battles over financial-statement transparency. In June the FASB released for comment an exposure draft of amendments to FAS 5, "Disclosure of Certain Loss Contingencies," that would require issuers to report "specific quantitative and qualitative information about those loss contingencies," including potential losses arising from litigation. Disclosures would require a description of how the claim arose, its legal or contractual basis, its current status, the anticipated timing of its resolution, and a summary of the factors that are likely to affect the ultimate outcome of the contingency. Issuers could apply for an exemption if disclosing certain required information "would be prejudicial to an entity's position in a dispute."

In the three-month comment period that followed, financial-statement users made their case for transparency. "When investors are not provided timely information regarding future losses and the resulting cash outflows, it can result in investors buying a security whose price is shortly thereafter negatively impacted by a surprise settlement or disclosure," wrote Lynn Turner, former chief accountant at the SEC and a member of Investors Technical Advisory Committee, a users group within the FASB.

But issuers--and those who represent them--were apoplectic about the exposure draft. The American Bar Association and the Association of Corporate Counsel contended in separate comment letters that attempting to provide loss contingencies for pending litigation would be inherently unreliable, compromise litigation strategy, breach the attorney-client and work product privileges, heighten litigation risk by providing plaintiffs with additional information, and increase compliance costs. In addition, the American Institute of Certified Public Accountants, as well as major auditing firms, expressed concern about the ability of auditors to verify loss-contingency disclosures, because lawyers who might corroborate such disclosures would be constrained by the attorney-client privilege.

"I just don't get what the problem is," says David M. Furbush, a partner in the Palo Alto office of Pillsbury Winthrop Shaw Pittman and co-leader of the firm's securities litigation team. Nor could most of the participants at a September conference on FAS 5 held at the Rock Center on Corporate Governance at Stanford University. In fact, two of the participants, Joseph A. Grundfest of Stanford Law School and Laura E. Simmons of the College of William & Mary Mason School of Business, presented a study of recent securities class action settlements that found no significant market reaction to settlement announcements--concluding that there really isn't a disclosure problem.

After reading the comment letters, the FASB backed off in late September, announcing FAS 5 would be subject to "redeliberations" that would include "field testing" of an alternative model to be considered early next year.

Furbush--who concedes that the existing FAS 5 rule doesn't require public companies to reveal much--likes the idea of field testing. "I had the impression from reading the exposure draft that FASB did not understand the litigation process," he says. "So field testing is a great concept. You take the historical data of a settlement or a case that went to trial, waive the attorney-client privilege, and ask for the case file. Then you analyze the case, asking, 'What could we have said ahead of time that would avoid concerns from the users of financial documents?' "

The FASB's alternative model, however, may never reach the field-testing stage. In October, Rep. Spencer Bachus (R-Ala.), ranking member of the House Financial Services Committee, urged SEC Chairman Christopher Cox to delay action "pending a thorough examination of the economic impact it could have on the competitiveness of U.S. issuers."

Given the prospects faced by many of those issuers, adding detailed loss contingencies to their balance sheets appears to be about as popular as fair-value accounting. Transparency--at least in the midst of a financial crisis--takes a back seat to survival.

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