The Outlook for More Breakthroughs in 2005

The mini-breakthroughs of 2004 were real, and they gave us reason for optimism. 2005 brings the potential for even bigger breakthroughs, but there are also pitfalls to avoid. Below are a few key areas to watch, along with our views and predictions.

The Promise of Principles-Based Standards

The elusive goal of principles-based standards will help shape standards issued in 2005 and beyond. We expect the FASB will continue to seek out ways to make its standards less "rules-based" and more "principles-based" or "objectives-oriented."

But real progress will demand more innovative thinking to define the goals and measure the risks and rewards in a more precise manner.

Today's renewed emphasis on internal controls may pay unexpected dividends in this regard. In the past, some stan-dards may have been rushed into effect, resulting in transition times too short to put the needed controls in place. Others may have required processes or systems that were costly to control and audit.

To learn from past mistakes, standard-setters and regulators need to build on these findings and factor into the goals of principles-based standards a more rigorous cost/benefit analysis. Ideally, the benefits analysis should focus on the needs of the various users of financial statements and consider the values of different types of information to different classes of users. Just as important, the costs should include the risks and consequences of making the wrong judgment or arriving at the wrong interpretation, despite a good faith attempt to comply with principles-based standards.

More Changes from International Convergence

The application of a more rigorous cost/benefit analysis will be especially important when weighing the need for additional convergence standards. Several short-term convergence projects are scheduled for completion in 2005. These projects could result in revisions to the standards for accounting changes and error corrections, income taxes, and research and development costs.

Accounting Changes

An exposure draft on accounting changes and error corrections was released in late 2003. If adopted as a final standard, this proposed standard would:

• Require that voluntary changes in accounting policies be applied by retroactive restatement.
• Require the use of retroactive restatement as the standard transition method for new accounting standards, unless a new pronouncement contains other specific transition guidance.

This proposal has met with resistance from those who fear restatement has taken on unfavorable connotations among users of financial statements. The concern is that these perceptions can be strong enough to outweigh any benefits of convergence.

Income Taxes

An exposure draft on accounting for income taxes is expected in 2005. The purposes of this ED are to:

• Eliminate some of the exceptions to the comprehensive deferred tax asset and liability principles of Statement 109. For example, the FASB has tentatively decided to eliminate the exceptions for intercompany transfers and foreign currency translation.
• Address certain "structural" differences with the international standard. These differences involve the use of backward tracing for interperiod tax allocation and the deferred tax assets arising in asset acquisitions other than a business combination.

Convergence on income taxes may prove difficult as the standards continue to respond to other events and trends. The FASB also plans to issue interpretations to address uncertain tax positions and the effects of income tax changes on the accounting for leveraged leases.

Research and Development

Although no specific timetable has been set, the FASB agreed in 2004 to try to eliminate differences with the international accounting standard for research and development. The primary focus is on the requirements related to initial recognition of intangible assets acquired in transactions other than a business combination.

A basic difference between U.S. GAAP and IFRS is that:

• The international standard makes a distinction between research and development and requires capitalization of development costs in certain circumstances.
• U.S. GAAP makes no distinction between research and development and generally requires both types of costs to be expensed when incurred.

The two Boards may try to build on the thinking in FASB Statement No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, as a framework for capitalizing internally-generated intangible assets.

A Bridge for the Gaps in Fair Value Measurement

The use of fair value measurement is a key area in which the costs and benefits have been especially difficult to measure. In what some have likened to the calm before the storm, the FASB released an exposure draft of a proposed statement on Fair Value Measurement in 2004. The intent of the proposed statement is not to introduce any new requirements for the use of fair value, but rather to provide uniform guidance on the definition and measurement of fair value.

The number of statements that require the use of fair value continues to grow, and the concept of fair value continues to evolve. As a result, the FASB felt it was time to bridge the gaps in the literature and reconcile the inconsistencies that have developed over time.

Critics of fair value measurement fear that, if and when a final statement is issued, it may serve as a signal to expand the use of this principle and move more elements of financial reporting across the bridge into the world of fair value measurement.

We are encouraged by the body of literature that is developing around the auditing of fair values. We hope the use of fair values won't be expanded without carefully weighing all the relevant risks and rewards in a rigorous cost/benefit analysis.

New Rules for Contingent Asset Retirement Obligations

In 2004, the FASB issued an exposure draft of a proposed Interpretation on Accounting for Conditional Asset Retirement Obligations. The biggest change in practice that would result from the ED is that the fair value of a conditional asset retirement obligation would be recognized when the obligation is incurred or as soon as the liability's fair value can be reasonably estimated.

A conditional asset retirement obligation is a legal obligation to take certain actions if and when a tangible long-lived asset is retired. An example would be the legal obligation to remove and dispose of asbestos, when a building is renovated or demolished. In this example, the asset retirement activity is viewed as "conditional" because it depends on a future event-renovation or demolition.

Current practice with respect to such obligations is mixed:

• Some companies interpret Statement 143 and Concepts Statement 6 to say that no liability exists until the triggering event becomes probable.
• Others have interpreted the literature to say that a liability exists and the probability of the triggering event affects the amount of the liability.

The ED embraces the second interpretation, (i.e., that a liability exists because of the legal obligation and that probability affects the measurement of the liability at fair value). In effect, this is a purer fair value model.

Despite its seemingly purer conceptual basis, the use of fair values for conditional future events is not without hazards, mostly because it introduces more risks and uncertainties associated with future events into the financial statements.

Companies are protected from liability by the safe harbor for forward-looking information provided in the Private Securities Litigation Act of 1995, provided they use appropriate cautionary language to identify the risks and uncertainties. But this safe harbor does not extend to financial statements. Because the cost of making a good-faith mistake could be substantial, we believe this risk should be weighed against the benefits.

Changing the Model for Business Combinations

Similar to the position taken by the FASB on contingent asset retirement obligations, the tentative conclusions of phase II of the FASB business combinations project reflect a more purist fair value approach.

Potential Changes in Applying the Purchase Method of Accounting for Business Combinations

Here is an overview of the FASB's current thinking as to how future accounting for business combinations would differ from today's accounting:

• Today's purchase accounting starts with purchase cost, including direct transaction costs, and allocates it to the acquired assets and liabilities based on relative fair values. There are exceptions, such as contingent consideration, which generally isn't recorded until the contingency is resolved.
• The proposed approach excludes transaction costs from purchase cost (because the FASB reasons that transactions costs don't represent part of the fair value of the acquired business). It also requires the buyer to estimate the fair value of contingent consideration and record it as a liability as part of purchase accounting. Any difference between fair value estimated at closing and actual payments would be an adjustment to the income statement because it would represent subsequent changes rather than fair value at the purchase date.
• The guidance on individual acquired assets and liabilities is also more detailed and intended to be closer to true fair value rather than an allocated amount.

Potential Changes in Accounting for Minority Interests

In addition, minority (noncontrolling) interests in consolidated subsidiaries would be classified as a component of equity rather than as a liability. As currently proposed by the FASB, this approach would substantially change the accounting for step acquisitions and dispositions. For example:

• A company that previously owned a noncontrolling interest in an entity would adjust that investment to fair value and recognize a gain or loss upon achieving control.
• Upon achieving control, the noncontrolling interest would be recorded at fair value, not at carryover basis.
• Further purchases after gaining control would be treasury stock transactions.
• No gain or loss would be recorded on partial dispositions unless they resulted in losing control.

Next Steps

The FASB has posted its tentative conclusions on this project to its website. If your company is an active acquirer, we recommend getting familiar with the proposed changes.

Our initial reaction is that on the whole the proposed changes are a step backwards, imposing heavy costs on both pre-parers and users of financial statements with little benefit.

Changing Roles for Auditors and Chief Financial Officers

As changes in accounting standards continue to evolve, future CFOs and auditors will face a tough new set of challenges. The driving forces:

• The trends toward convergence, principles-based standards and greater use of fair values all complicate the movement toward a tougher regulatory and enforcement environment. These trends result in accounting rules that are complex, constantly changing, and difficult to apply without consultations with auditors and outside experts.
• So pronounced are the trends in accounting standards that critics predict the world may soon see the day when it is no longer possible for an accountant to master all the authoritative literature and apply it without the aid of an army of specialists. Indeed, some say that day has already dawned.
• Yet rigorous ethical standards increasingly call for greater separation of audits and non-audit services, causing companies to deal with an increasing number of accounting and consulting firms to find the necessary specialists.
• At the same time, internal control requirements for public companies encourage preparers of financial statements to make their own interpretations of complex standards rather than relying on their auditors' interpretation.

These challenges demand innovative thinking. By rising to the challenge, academics, preparers, auditors, regulators and standard-setters all can help ensure that financial reporting will continue to evolve and improve. The keys to success will include a rigorous cost-benefit analysis, a concerted effort to avoid overloading the system, and a conscious effort to weigh the impact on private, small and mid-sized companies.

Both auditors and CFOs will need to be prepared for change. But the breakthroughs of 2004 give us reason for optimism. Changing roles can succeed, if we continue to build on knowledge, one step at a time, step- by- step, breakthrough by breakthrough.

For more updates

The following publications provide more details about the accounting matters mentioned in this letter. They are available on BDO's web site at http://www.bdo.com/services/assurance/.

• Employers Brace for Expected Changes in Accounting for Stock Options
• FASB Statement No. 150 Brings Big Changes
• New Accounting Rules for VIEs - aka SPEs
• SEC Year in Review - Significant 2004 Developments
• SEC Insights - 2004

The following publications provide more details about the tax matters mentioned in this letter. They are available on BDO's web site at http://www.bdo.com/about/publications/tax/index.asp.

• Washington Tax Report - Deduction for Domestic Production Activities Income
• Washington Tax Report - American Jobs Creation Act of 2004

You may also wish to join us for our quarterly conference calls on new accounting development. For more information, see http://www.bdo.com/about/publications/assurance/index.asp.

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