The 'Carrot' Approach to Accounting Standard Setting

In December 2006, Conrad Hewitt, the chief accountant at the Securities and Exchange Commission (SEC), promised that the issue of complexity in accounting would be addressed early in 2007 and would be a leading focus of work by his office in 2007. The goal in financial reporting is to disseminate transparent, understandable, financial information that fairly presents the financial condition of the reporting company. Oftentimes, however the information public companies disseminate is overly complex, quagmired in legalistic form at the expense of true economic substance, and is devoid of conveying true, meaningful and understandable information regarding the company.In this regard, the SEC, in conjunction with the Financial Accounting Standards Board (FASB), is making an attempt to remedy this problem by exploring ways to simplify the fragmented and complex accounting regime currently in existence. The goal of this Article is to highlight one aspect of this reform effort that must be addressed to insure success of the SEC's stated objective of a more simplified accounting and financial reporting system. The aspect in question is management and its role in the accounting and financial reporting process.Corporate management is primarily responsible for a company's financial reporting. This dynamic, at times, can put the interests of those who prepare financial statements at odds with the users of such information. The conflict stems from the structure of executive compensation. For many corporate executives, a significant portion of their compensation is incentive-based, i.e. tied to the company's financial performance. Thus, a corporate manager's bonuses, stock options, or even continued employment, might be linked to the figures reported in its financial statements.Because of this Incentive Based Compensation (IBC) component, management, in many cases, may be adversely affected if the reported financial results are unfavorable; stock options may not be as valuable for example, or an executive's bonus that is based on corporate profitability may not be realized if certain financial benchmarks are not met. This Article contends that these types of conflicts create the disincentive for management to report financial information accurately when that information is less than favorable.Accordingly, this conflict, if not properly addressed, will make the goal of a less complicated accounting regime remain a mere aspiration rather than an achievable objective. The trappings of IBC incentivize managers to engage in either aggressive accounting tactics that compromise financial statement integrity, or to commit outright accounting fraud. Consequently, accounting standard-setters are forced to draft standards "defensively" in anticipation of, and in reaction to, financial preparers who want to push the limits of accounting boundaries as far as possible to further their own personal stakes. This Article contends that the move to a more simplified accounting and financial reporting regime can only be achieved when this tension between preparers and users of financial information is alleviated. To that affect, the Article will proceed as follows. Section II provides context and frames the debate by explaining the tension-causing link between IBC and financial reporting. Section III then explores the resulting effect that IBC has had on accounting standards. Section IV then discusses the likely changes to the accounting and financial reporting framework and the potential obstacles that may make such an undertaking difficult. Section V then proposes some solutions to the problem of IBC and its adverse affects on accounting standards, the gist of which is to realign management's incentives by incentivizing accurate financial reporting instead of tying IBC to financial performance. Finally, Section VI concludes by summarizing the argument and re-urging the practice of incentivizing accurate financial reporting.