CA1-16 (Economic Consequences) SOLUTION

CA1-16 
(Economic Consequences) Presented below are comments made in the financial press.
Instructions
Prepare responses to the requirements in each item.

(a) Rep. John Dingell, at one time the ranking Democrat on the House Commerce Committee, threw his support behind the FASB’s controversial derivatives accounting standard and encouraged the FASB to adopt the rule promptly. Indicate why a member of Congress might feel obligated to comment on this proposed FASB standard.

(b) In a strongly worded letter to Senator Lauch Faircloth (R-NC) and House Banking Committee Chairman Jim Leach (R-IA), the American Institute of Certified Public Accountants (AICPA) cautioned against government intervention in the accounting standard-setting process, warning that it had the potential of jeopardizing U.S. capital markets. Explain how government intervention could possibly affect capital markets adversely.

Solution

(a)    Considering the economic consequences of GAAP, it is not surprising that special interest groups become vocal and critical (some supporting, some opposing) when rules are being formulated. The FASB’s derivative accounting pronouncement is no exception. Many from the banking industry, for example, criticized the rule as too complex and leading to unnecessary earnings volatility. They also indicated that the proposal may discourage prudent risk management activities and, in some cases, could present misleading financial information.

As a result, Congress is often approached to put pressure on the FASB to change its rulings. In the stock option controversy, industry was quite effective in going to Congress to force the FASB to change its conclusions. In the derivative controversy, Rep. Richard Baker introduced a bill which would force the SEC to formally approve each standard issued by the FASB. Not only would this process delay adoption, but could lead to additional politicization of the rule-making process. Dingell commented that Congress should stay out of the rule-making process and defended the FASB’s approach to establishing GAAP.

(b)    Attempting to set GAAP by a political process will probably lead to the following consequences:

(a)   Too many alternatives.

(b)   Lack of clarity that will lead to inconsistent application.

(c)   Lack of disclosure that reduces transparency.

(d)   Not comprehensive in scope.

Without an independent process, GAAP will be based on political compromise. A classic illustration is what happened in the savings and loan industry. Applying generally accepted accounting principles to the S&L industry would have forced regulators to restrict activities of many S&Ls. Unfortunately, accounting principles were overridden by regulatory rules and the resulting lack of transparency masked the problems. William Siedman, former FDIC Chairman noted later that it was “the worst mistake in the history of government.”

Another indication of the problem of government intervention is shown in the accounting standards used by some countries around the world. Completeness and transparency of information needed by investors and creditors is not available in order to meet or achieve other objectives.