Herz: Accounting Did Not Cause the Crisis!

Financial Accounting Standards Board Chairman Robert Herz refuses to accept the inevitability of another financial system collapse.

In a speech at the National Press Club in Washington last week, Herz offered his personal perspective on the causes of last year’s meltdown, and the principles that must govern systemic reform efforts, including those impacting the public accounting profession.

“History does not repeat itself – people repeat history,” he declared. “So the lessons learned will help us build a sounder, stronger financial system.”

Among the lessons learned was the need for “enhanced disclosure requirements relating to securitizations and special-purpose entities, credit default swaps and derivatives, financial guarantee insurance, and fair value measurements and credit exposures.”

Herz said that while the accounting profession “did not cause the crisis and accounting will not end it,” the crisis highlighted the need for tighter disclosure in those areas. FASB, he said, has “responded vigorously” with proposals to accomplish that.

Accountants don’t operate in a vacuum, he added. “Lack of proper regulation and risk management, unsound lending and securitization practices and the absence of proper market infrastructures” create an environment in which “accounting and valuation are significantly challenged.”

“Proper accounting and valuation,” Herz said, “require that companies and market participants identify, understand and reasonably calibrate risks and returns emanating from financial assets and obligations, and be able to readily ascertain transaction prices in exchange markets.”

Responding to a question following his speech, Herz acknowledged the challenge of valuing assets, such as distressed mortgage-backed securities, when no or few transactions take place. “That is at the core of the more thorny issues that have arisen,” he acknowledged. It is also the case with “opaque” markets, where “it is not always clear who the parties are, what the motivations are, whether there are distressed sellers.”

Herz noted that FAS 157, which addresses fair value measurement, was issued in 2006, but was not the accounting profession’s first try at getting a handle on the topic. “Fair market value has been around for time immemorial,” he said.

Accounting standards, Herz said, must be established in an environment without undue political influence. “Unfortunately,” he said, “there have been certain major companies … and industry trade groups that have sought political intervention into accounting standard-setting."

“The investing public expects and deserves unbiased and transparent financial information that is not skewed to favor particular transactions, companies or industries,” he added.

Responding to a reporter’s question, he noted that former AIG chairman Martin Sullivan “spent a fair amount of time on Capitol Hill trying to convince lawmakers that there were no problems with credit default swaps” before AIG’s $150 billion federal bailout.

Herz endorsed the view that credit default swaps should trade on exchanges. “Without infrastructures to facilitate the timely flow of relevant and reliable information that enabled informed decisions, ready price discovery and effective clearing mechanisms, markets can become dysfunctional,” he said.

Herz also made the following points:

• Bank regulators’ efforts to set bank capital requirements should not be “inappropriately handcuffed by requirements that they conform to their treatments to GAAP;”

• Improved transparency and corporate governance are needed to address executive compensation practices at companies where “perverse incentives” motivated CEOs to embark on “high-risk strategies;” and,

• The U.S. needs to take “very seriously” foreign criticism of the nation’s ability to “run sound capital markets and a reliable financial regulatory system,” and engage with other accounting standards organizations to address systemic deficiencies.