1.5 The Need for Financial Accounting Standards

Imagine a company that compensates a key employee in the following ways:

• A cash salary of $80,000

• A new car with a value of $30,000

• An option to become a 10 percent owner of the company in one year in exchange for an investment of $200,000

If the company does well in the coming year, the company will increase in value, the $200,000 price tag for 10 percent ownership will look like a great deal, and the employee will exercise the option. If the company does poorly, it will decline in value, the $200,000 price will be too much, and the employee will throw the option away and forget the whole thing. The company also sells these ownership options to interested outside investors for $25,000.

How would you summarize in one number the company’s compensation cost associated with this employee? We would probably all agree to include the $110,000 ($80,000 + $30,000) compensation cost from the cash salary and the new car. What about the option? The following two arguments could be put forward:

• If the employee were to buy the option from the company just like any other outside investor, the employee would have to pay $25,000. Therefore, giving the option to the employee is just like paying him or her $25,000 cash. The $25,000 value of the option should be added to compensation cost.

• The option doesn’t cost the company a thing. In fact, the option merely increases the probability that the employee will invest $200,000 in the company in the future. The option doesn’t add a penny to the compensation cost.

So which argument is right? Should each company decide for itself whether to include the $25,000 option value as part of compensation cost, or should there be an overall accounting standard followed by all companies? And if there is a standard, who sets it?

There are many situations in business, such as the option compensation case just described, in which reasonable people could disagree about how certain items should be handled for accounting purposes. And because financial accounting information is designed to be used by people outside a company, it is important that outsiders understand the rules and assumptions used by the company in constructing its financial statements. A company’s rules and assumptions would be extremely difficult and costly for outsiders to discover if every company formulated its own set of accounting rules. Accordingly, in most countries in the world a committee or board exists to establish the accounting rules for that country.

In the United States, accounting standards are set by the Financial Accounting Standards Board (FASB). The FASB is based in Norwalk, Connecticut; its seven full-time members are selected from a variety of backgrounds—professional accounting, business, government, and academia. It receives most of its $29.5 million annual operating budget through annual accounting support fees from public companies, as required under the Sarbanes-Oxley Act. The remainder is generated through donations and through sales of publications and other services. The FASB is not a government agency: it is a private body established and supported by the joint efforts of the U.S. business community, financial analysts, and practicing accountants.

Because the FASB is not a government agency, it lacks the legal power to enforce the accounting standards it sets. The FASB maintains its influence as the accounting standard-setter for the United States (and the most influential accounting body in the world) by carefully protecting its prestige and reputation for setting good standards. In doing so, the FASB must walk a fine line between constant improvement of accounting practices to provide fuller and fairer information for external users and pratical constraints on financial disclosure to appease businesses that are reluctant to disclose too much information to outsiders. To balance these opposing forces, the FASB seeks consensus by requesting written comments and sponsoring public hearings on all of its proposed standards. The end result of this public process is a set of accounting rules described as generally accepted accounting principles (GAAP). Without general acceptance by the business community, FASB standards would merely be theoretical essays by a powerless body, and the FASB would be disbanded. This may sound overly dramatic, but the FASB was created in 1973 to replace the previously existing accounting standards body (the Accounting Principles Board), which had lost its credibility with the business community because it was seen as being completely controlled by accountants.

As you study this text, you will be intrigued by the interesting conceptual issues the FASB must wrestle with in setting accounting standards. The FASB has deliberated over the correct way to compute motion picture profits, the appropriate treatment of the cost of dismantling a nuclear power plant, the best approach for reflecting the impact of changes in foreign currency exchange rates, and the proper accounting for complex financial isntruments such as commodity futures and interest rate swaps. And because U.S. companies are always suspicious that any change in the accounting rules will make them look worse on paper, almost all FASB decisions are made in the midst of controversy.

Questions