In particular, Robert Herz merely asserted his beliefs without adding any logic or any evidence that the reporting system is too complex. Worse, he touts principles-based accounting as the savior for the world of financial reporting, but again provides no argumentation to support his hypothesis. Maybe it’s because there is none. (Read the full speech.)

See also: Cox Encourages Simpler Accounting: Bah, Humbug! Christopher Cox Doesn't Reside at Pooh Corner FASB's Efforts Toward Simplification Earnings Per Share: An Example of Principles-Based Accounting? Accounting Rules: Why Simpler Isn't Necessarily Better

Given that we have two chairmen making some brash comments about the complexity of accounting, let’s investigate this further. Is complexity really bad? Is complexity really the major problem with financial reporting?

Is complexity bad?

Suppose a patient visits his or her general practitioner about some medical problem. After some initial testing, the general practitioner refers the patient to a specialist. The patient obtains a copy of the referral letter, but has difficulty reading it. Should a government agency intervene, complaining that the letter is "too complex" and require medical doctors to apply plain English?

I think the answer is obvious -- of course not. When one doctor writes to another physician, he or she may employ scientific jargon. They are both trained in biology, chemistry, and medicine. The complex vocabulary and the complex theories that they utilize actually improve the communication process. The additional complexity allows a doctor to make more precise statements about the patient's condition and about possible solutions to the medical problem. Requiring plain English statements would create greater ambiguity and distort the communication process.

Of course, when the doctor talks with the patient, he or she must use plain English. Because the patient does not have medical training, the patient will not understand the more precise language and therefore the communication process will suffer if the physician employs medical language. As the physician employs the less precise language of everyday English, the patient will learn more about the medical problem and possible future tests. Some communication with a less precise language is better than virtually no communication with a more powerful language designed for experts.

While the analogy isn't perfect, it fits the accounting scenario. When business enterprises report on their financial condition and on their results during the past year (or quarter), they can more precisely convey their message by applying a more precise accounting language. This text, however, is meant for those trained in finance and in accounting. Complexity can actually improve the communication process when the recipient is a sophisticated user.

Naïve financial statement readers may not understand the language of accounting, but they are not necessarily hurt by that situation. Just as general practitioners can revert from a medical language to everyday language when they speak with patients, financial analysts and brokers can employ plain English when they speak with clients. In this manner, the messages contained in an annual (or quarterly) report become disseminated to a wide audience.

More precise language and better economic theories will improve the communication between business enterprises and sophisticated users, even if the reports are complex. Sophisticated users can then translate the messages into plain English and convey these stories to naïve users.

Is complexity really the major problem?

When remonstrating the overly complex accounting rules and when touting principles-based accounting, Chairman Herz points to "bright lines" as an example of what's wrong with current-day standards. I agree with him that such bright lines constitute a problem, but the problem isn’t the complexity introduced by these bright lines. The problem is that these bright lines are arbitrary and capricious. Instead of relying upon economic theory, the FASB (and the SEC whenever it enters the skirmish) has invented these bright lines that have no meaning and no empirical referent.

Consider leases: the FASB created the 90 percent cutoff point for deciding whether a lessee had to capitalize a lease, but it never informed us why. If the present value of the future cash commitments equals 89.9 percent of the property's fair value, then the lease is an operating lease; but if it equals 90 percent, then the lease is a capital lease. What economic theory does the FASB rest its decision on? No theory at all. The board randomly and recklessly introduced this bright line into the literature.

If the board really wanted to improve financial reporting, then it would require lessees to capitalize all leases that had duration greater than one year. You introduce no fictitious bright lines and ironically, you simplify the accounting! More importantly, the rule would require corporations to tell it as it is rather than distort the economic reality of the lease.

Consider pensions: the FASB concocted the corridor rule to decide what gains and losses could be hidden from the income statement and what had to be reported. There is no theory to support this notion of telling white lies when it comes to pension fund gains and losses. The FASB also fabricated the notion of an intangible pension asset only because it had a dangling credit in search of something to debit. This intangible pension asset is clearly intangible, so much so that nobody will ever see or comprehend it; unfortunately, to call the item an asset is a lie. With no theory or thought about economic reality, the board again randomly and recklessly introduced the bright line of the corridor method and the misnomer of intangible pension asset.

If the board really wanted to improve financial reporting, then it would eliminate much of the nonsense that molds Statement No. 87. Record the gains and losses on the pension fund, value the pension fund at fair value, record the pension obligation at its present value, and don’t leave off any component as "unrecognized." You introduce no fictitious bright lines and no silly and irrelevant terms; and, ironically, you simplify the accounting while insisting that business enterprises display and measure the economic reality of the pension.

As a third and final example, consider special purpose entities (SPEs). To their shame, the FASB and the SEC has allowed corporations to hide SPEs. Those rules weren't complex; they just didn’t exist! And after Enron, the FASB invented "variable interest entities" and a couple of rules to decide whether companies had to consolidate those variable interest entities. But, the board really didn’t have to go to all that trouble, designing arbitrary and capricious rules about when to consolidate. The right principle was to require the consolidation of all commitments that a business entity has. Simple -- and economically sound.

Many other examples exist, and I will produce them if Mr. Herz still cannot perceive the reality. He and other board members have acted whimsically as they invent one distortion after another. No, the problem isn’t complexity; the problem is a board that has lost its direction. Instead of demanding firms to report economic reality, they fabricate concepts devoid of meaning and mandate hallow and inconsequential measurements. The problem is arbitrary and capricious rule-making.

Conclusion

Who is creating these bright lines? Who is inventing fiction after fiction? Who is passing arbitrary and capricious accounting standards? Even if the problem is complexity, let's ask who made the system that way. Indubitably, the FASB did all of these things. So if we want a system that reports the economic truth, we need to get rid of those responsible for the bright lines, for the silly fictions introduced into the literature, and for the arbitrary and capricious rules.

See also: Cox Encourages Simpler Accounting: Bah, Humbug!

*The American Institute of CPAs hosted its national conference in Washington, D.C., with representatives from the Securities and Exchange Commission and Public Company Accounting Oversight Board.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.