How to measure the costs and benefits of a standard?
The FASB’s Conceptual Framework imposes a cost constraint in U.S. GAAP (see paragraphs 35-39 of SFAC No. 8, Chapter 3), which essentially states that the Board must assess whether the benefits of a proposed standard justify its costs. In recent weeks, several FASB constituents have urged the Board to give greater consideration to the cost constraint. In a comment letter on the Financial Accounting Foundation’s (FAF) proposal to establish the Private Company Standards Improvement Council (PCSIC) (here), the Financial Reporting Policy Committee of the Financial Accounting and Reporting Section of the American Accounting Association (AAA) strongly recommends that the “FASB consider serious improvement of the cost-benefit analyses that are done for new accounting standards during their development” (p. 17). Similarly, in a report issued by KPMG and the Financial Executives Research Foundation (FERF) on disclosure overload and complexity (here), one of eight recommendations is,
“The FASB and SEC should undertake incremental procedures to ensure that there is an appropriate and adequate cost-benefit analysis in support of all new disclosure requirements. This should include expanded field testing of disclosure proposals.”
In addition, as part of their post-implementation review of FASB Interpretation No. 48 (FIN 48) (here), the FAF issued several recommendations, including,
“We recommend that the FASB include in each standard a thorough discussion of the new guidance’s benefits and beneficiaries, the associated costs to affected principal stakeholders, and how benefits and costs are evaluated and assessed” (p. 11).
These are just three examples of various organizations urging for a more formal and transparent cost-benefit analysis (CBA) when the FASB promulgates standards.
The FASB’s current methodology of analyzing costs and benefits relies primarily on the judgment of individual Board members based on their own experiences and mostly qualitative data from outreach activities. The Board receives information on the costs and benefits of a proposed standard from a wide variety of constituents, including, advisory committees, task forces, industry representatives, and professional groups. In addition, formal field tests are sometimes performed to gain a better understanding of the actual costs of implementation. Sometimes, academic research can inform on the potential benefits of a proposed standard. Board members sequentially process the information obtained from all of their outreach activities, and deliberate the expected costs and benefits before deciding on a final standard.
The Board’s assessment of costs and benefits has led directly to several decisions. For example, private companies have been permitted exceptions to disclosure requirements, and they are often granted extended time to implement standards. These decisions are based on the perceived differential costs and benefits from implementing the standard for private companies. In addition, new standards have been adopted that eliminate or substantially reduce the requirements of previously issued standards in an effort to reduce costs without sacrificing perceived benefits. For example, based largely on academic research showing limited benefits to supplementary inflationary disclosure requirements required under Statement 33, the FASB eliminated these requirements in Statement 89. More recently in Accounting Standards Update (ASU) 2011-08, the FASB revised guidance to assess impairments of goodwill to lower the annual costs to comply with this standard without significant sacrifice in benefits. Similar guidance is now being deliberated for the impairment of intangible assets with indefinite lives. All of these examples illustrate that the FASB takes seriously the cost constraint imposed by their Conceptual Framework. However, FASB constituencies continue to push the FASB towards implementing a more conventional and transparent CBA.
Advocating that benefits from a specific standard must exceed its costs is safe ground; of course, who wouldn’t agree with this notion? Like any type of imposed regulation, there must be serious consideration about the costs and benefits since market forces are being circumvented. The more difficult issue, however, is attaching monetary values to costs and benefits. In theory, I suppose costs of a standard could be measured by determining the relevant and incremental costs that its issuance imposes. These costs would include:
One-time costs to become familiar with the new standard (e.g., training and education costs).
- Costs incurred by preparers to change their information systems to gather new information required by the new standard, retrospectively restate information from the old standard, and maintain compliance.
- Costs incurred by auditors to change their audit procedures and verify information.
- Costs incurred by users to change their methods of interpreting information produced by preparers, including costs incurred to determine whether information is incremental or redundant.
Measuring these costs would not be an easy task. And, performing a conventional CBA is itself a cost-benefit proposition. Are the costs of quantifying the costs (and benefits) worth the benefits of doing so?
When it comes to benefits, things get even more messy. The sole objective for issuing any new standard and also, its sole benefit is to facilitate a more efficient allocation of resources, the outcome of which is far-reaching. Companies realize a lower cost of capital while individuals enjoy higher rates of return with fewer losses. In turn, these direct outcomes lead indirectly to higher macroeconomic growth and lower unemployment. These indirect benefits are incremental and should be considered in a conventional CBA. Also, market bubbles are less likely to be created, which reduces the likelihood that companies will realize sudden losses in market values. This outcome further enhances public confidence in financial reporting. How can standard-setters quantify these benefits? I don’t know of any method that could practically do so, especially on an ex ante basis.
Any ideas from academics on how standard setters can conduct a more effective CBA?