Lobbying by auditors and financial institutions on proposed accounting standards

by Heidi Hylton Meier, D.B.A., CPA , Pervaiz Alam, Ph.D., CPA** and Michael A. Pearson, D.B.A., CPA, CMA***

Lobbying by auditors and their financial institution clients on proposed accounting standards is not at all uncommon. Standard-setting bodies, in fact, usually welcome lobbying efforts in the hopes that all points of view are heard.

Do auditors, however, offer their own assessments of proposed standards, or do they advocate their financial institution clients' positions in order to maintain favorable relationships? Auditor objectivity is essential to the public interest. As noted by the Public Oversight Board (POB), permitting clients to bias auditor responses to proposed standards "damages the standard-setting process and the interpretive process by denying those processes benefits that would otherwise be obtained from objective, wellreasoned and well-researched analyses of the issues."1

The lobbying process is described in this article, and possible reasons for lobbying are noted. As a specific example, we analyze efforts to affect proposed accounting standards dealing with banks and savings and loan associations (S&Ls).

LOBBYING AND THE STANDARD-SETTING PROCESS

The consequences of the accounting standard-setting process are many. At a minimum, some implementation costs are incurred every time a proposed accounting standard is adopted. Ideally, though, the benefits derived from higher quality accounting information exceed the sum of these implementation costs.

Each of us has a stake in the standard-setting process and its outcome because every new accounting pronouncement has an impact on manyand sometimes all-preparers, auditors, and users of accounting information. As such, some individuals and groups take steps to ensure the Financial Accounting Standards Board (FASB) is aware of their viewpoints; this is often referred to as "lobbying."

Lobbying is a part-some might claim an important part-of the FASB accounting standard-setting process. FASB states it is interested in input from its many constituencies, and, accordingly, the board has set up a formal lobbying mechanism.

FASB, the designated private-sector organization responsible for financial accounting standards, follows an extensive "due process" system open to public observation and participation. This system, modeled after the Federal Administrative Procedures Act, ensures lobbyists-whether preparers, auditors, or users of accounting information-are given the opportunity to provide input in the standard-setting process. Before a Statement of Financial Accounting Standards (SFAS) is issued, a FASB project will typically pass through the following sequence of steps:

1 ) Appointment of a task force

2) Issuance of a discussion memorandum (DM)

3) Public hearing

4) Analysis of oral and written comments

5) Meeting of FASB

6) Issuance of an exposure draft (ED)

7) Further FASB deliberations

Lobbying can take place at any point in the standard-setting process, although FASB specifically requests "lobbying" at public hearings and in response to the issuance of DMs and EDs. Sometimes lobbying actually continues after a final pronouncement has been issued because lobbyists hope to change the standard setters' minds concerning an issue. FASB maintains a file of all responses-written and oral-to proposed accounting standards, and the file is open for public scrutiny.

REASONS FOR LOBBYING

Some individuals and groups, of course, lobby in favor of or against a proposed accounting standard because they believe they know what is "right." Others might lobby in favor of or against depending on what is in their best interests. For example, preparers of accounting information might oppose a pronouncement that will require them to accumulate and publish more information for users; but users might support that same pronouncement because it will aid them in their decision making.

In the case of lobbying by auditors, a number of theories have been suggested. One, for example, hypothesizes auditors will always lobby for positions advocated by their clients because clients have the ability to hire and fire auditors at will. Another theory suggests because the economic interests of auditors and their clients differ, the positions they support on proposed accounting standards may also differ. Instead of proposing auditors are controlled by their clients, this theory suggests clients and auditors act in their own self-interests.

Various reasons for client lobbying have been theorized. Some of the factors identified as affecting client lobbying positions include taxes, political costs, bookkeeping costs, and client management wealth. Other research studies indicate firm size, leverage, and the percentage of client management ownership may also provide an explanation for client lobbying.

LOBBYING FOR STANDARDS AFFECTING BANKS AND SAVINGS & LOAN ASSOCIATIONS

To determine the extent and nature of lobbying for proposed accounting standards affecting banks and S&Ls, we examined comment letters sent to FASB. An industry guide published by Ernst & Whinney (now Ernst & Young) was used to identify the issues banks and S&Ls deemed most important.2 Only those issues identified in the guide and also considered by FASB were considered for inclusion in our study.

All comment letters pertaining to four exposure drafts of Statements of Financial Accounting Standards (SFAS), two proposed Technical Bulletins (TB), and an Invitation to Comment (ITC) were examined. The titles of the later-adopted SFASs and TBs and the title of the ITC are:

1) Statement of Financial Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings"

2) Statement of Financial Accounting Standards No. 65, "Accounting for Certain Mortgage Banking Activities"

3) Statement of Financial Accounting Standards No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions"

4) Statement of Financial Accounting Standards No. 80, "Accounting for Futures Contracts"

5) Technical Bulletin 85-1, "Accounting for the Receipt of Federal Home Loan Mortgage Corporations Participating Preferred Stock"

6) Technical Bulletin 85-2, "Accounting for Collateralized Mortgage Obligations"

7) Invitation to Comment, "Accounting for Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans"

An SFAS specifies accounting standards for major accounting issues. TBs address emerging problems, specialized industry accounting questions, and issues not directly covered by existing standards. An ITC is distributed as a means of soliciting comments and inviting readers to identify issues they feel should be included in a particular FASB project.

The above list of proposed standards would ultimately have a significant impact on the earnings and equity positions of banks and S&Ls. For example, SFAS No. 15 would require placing problem loans on a non-accrual basis, significantly impacting the institution's earnings; while SFAS No. 65 would require banks and S&Ls to use the lower of cost or market method to account for mortgage loans and mortgage-backed securities held for sale.

Earnings were also impacted by SFAS No. 72 as banks and S&Ls were singled out, requiring goodwill resulting from the acquisition of another institution to be amortized over a shorter period of time than other entities. SFAS No. 80 provided practical advice concerning futures transactions, which have played a major role in the asset/liability management of financial institutions; while TB 85-2 required collateralized mortgage obligations to be classified as borrowings; and the ITC required income received from loan origination and commitment fees to be deferred rather than recognized immediately.

Analyzing TB 85-1 offers a good example of the lobbying process at work. TB 85-1 provided guidance on accounting for a one-time stock dividend distributed by the Federal Home Loan Mortgage Corporation (FHLMC) to S&Ls that were members of the Federal Home Loan Banking System. When FASB first confronted this issue, its preliminary conclusions were the stock dividend did not represent an asset nor extraordinary income to the recipient S&Ls. (Traditional accounting for stock dividends usually entails only an allocation of the acquisition cost of the original investment to the sum of the original number of shares and the additional shares received from the dividend.) These deliberations were followed by an intense outcry from the member S&Ls for further consideration by FASB. This led to a request by FASB for additional information about the issue from the Federal Home Loan Bank Board, the FHLMC, and a private brokerage firm. Shortly thereafter, FASB released a proposed TB which called for the recognition of the stock dividend as an asset. To this proposed TB, FASB received 254 comment letters from S&Ls, auditors, and others; and almost all these letters supported the proposal. Subsequently, FASB issued TB 85-1 which provided for precisely the treatment described in the proposed TB. The language of TB 85-1 adopted after FASB's due process deliberations indicates FASB was persuaded the appropriate accounting treatment of the stock dividend was to have it recorded at its fair value as an asset and the resulting income classified as extraordinary.

EXTENT OF COMMENT LETTERS

Exhibit 1 lists the total number of comment letters sent to FASB on each of the SFAS exposure drafts, proposed TBs, and the ITC included in our study. The letters are further categorized by respondent groups: auditing firms, banks, S&Ls, industry, academia, government, representative bodies (e.g., Financial Executives Institute, American Bankers' Association, United States League of Savings Institutions), and others. The exhibit shows TB 85-1 and the ITC received the greatest number of comment letters, and most of these letters were from S&Ls. Exhibit 2, Panel A, focuses solely on financial institutions and indicates the number of different banks and S&Ls (combined to be consistent with FASB's description of the "Banking and Thrift Industries") that contacted FASB on the issues in our study; Exhibit 2, Panel B, provides the same information for auditing firms.

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Exhibit 2 shows no one bank or S&L sent comment letters to FASB on all seven issues; the most issues any financial institution commented on was five. The responding financial institutions represent all facets of this industry from very small, mutual S&Ls to very large international banks. Approximately one-half of the institutions are classified as small institutions (assets less than $1 billion), while another one-third are classified as medium-sized (assets between $1 and $10 billion), and the remaining institutions are classified as larae (assets exceeding $10 billion).

Five auditing firms did comment on all seven issues. Two other firms responded to six of the seven issues, and one firm commented on five. It should be noted these eight most active lobbying firms are those which were commonly known as the "big eight." No non-big eight firm commented on more than two of the seven issues we studied.

NATURE OF COMMENT LETTERS

Because many SFAS exposure drafts, proposed TBs, and ITCs address more than one point, authors of comment letters do not necessarily support, oppose, or offer remarks on an entire document. Hence, for each of the seven issues in our study, important sub-issues were identified. The exposure draft which later resulted in the issuance of SFAS No. 72, for example, was deemed to contain two sub-issues: 1 ) Should the amortization period of goodwill resulting from the merger or acquisition of a bank or S&L be related to the long-term interest-bearing assets acquired? 2) Should financial assistance provided by a regulatory agency in connection with mergers or acquisitions be accounted for as a part of the combination if the receipt of the assistance is probable and can be reasonably estimated?

Two sub-issues were identified for each of the SFAS exposure drafts in our study; four sub-issues were identified for the ITC; but only one issue (hereafter referred to as a sub-issue) was noted for each proposed TB.3 Every comment letter was scrutinized and coded as being either in favor of, against, or "indeterminable/no comment" with respect to each subissue. (Positions in favor of or against each sub-issue could be determined for all auditing firms but not all financial institutions included in this part of the study.)

Because we were interested in the positions espoused by auditing firms and their banking and S&L clients, we attempted to identify the audit firm for each bank and S&L that sent FASB a comment on any of the seven issues in our study. By sending letters, making phone calls, and consulting published sources, we were able to obtain the names of auditing firms (for the years the exposure drafts of the SFASs, the proposed TBs, or the ITC were released) for all the banks and all but 20 of the S&Ls. Of course, positions of the commenting banks and S&Ls could be compared to the positions of their auditing firms only when the auditing firms had also submitted comment letters to FASB on the same issue. Exhibits 3 and 4 provide analyses of matchable positions on the sub-issues in our study.4

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With respect only to matchable positions, Exhibit 3 indicates the percentage of auditing firms and financial institutions that lobbied in favor of and against each sub-issue. One can see, for example, proposed TB 85-1 was supported by 100 percent of the auditing firms and all but 1 percent of the financial institutions. On the other hand, almost two-thirds of the financial institutions were against the first sub-issue in the SFAS No. 65 exposure draft. but 100 percent the matchable-position data in an alternative way.

Exhibit 4 presents the matchable-position data in an alternative way. The extent of agreement between the individual financial institutions and their auditing firms is shown. The data show auditors and their financial institution clients sometimes took the same positions but often differed in their positions on the various sub-issues in the study. Exhibit 4, for example, shows of the 14 sub-issues examined, in seven instances more than 50 percent of the financial institutions and their auditors took the same position. But, on three of the sub-issues, more than 50 percent took different positions. And, on two of the remaining sub-issues, the percentage of cases in which financial institutions' positions were the same as their auditors is identical or almost identical to the percentage of cases in which positions were different.

To reiterate, the firms formerly known as the "big eight" are the most active in the auditor lobbying process, at least in terms of comments submitted to FASB on the seven issues in this study. Because of both the limited involvement of non-big eight firms and the limited involvement of their clients, almost all of the matchable-position auditing firm data in Exhibits 3 and 4 are big eight firm data. In fact, all of the matchable-position data dealing with auditing firm lobbying on the drafts/proposals which later resulted in the issuance of SFAS No. 15, SFAS No. 65, SFAS No. 80, and TB 85-2 come from big eight comment letters.

Of interest are the positions taken by the four auditing firms which in particular are known to have had significant numbers of banking and S&L clients. Touche Ross, Deloitte Haskins & Sells, and Ernst & Whinney sent comment letters on all the issues in this study. Peat, Marwick, Mitchell sent letters on all but one. These firms showed no consistent patterns in their lobbying. They neither acted as a cartel, all lobbying in the same direction, nor were they consistently opposed to one another.

CONCLUSIONS AND LIMITATIONS

Permitting auditors to lobby on accounting standards presents risks for society but also offers benefits. One risk is auditors will blindly advocate the positions taken by their clients. Auditors, it could be argued, have an incentive to advocate their clients' views because the clients might replace the auditors if they endorse contrary opinions. The benefits from auditor lobbying relate to the potential for higher quality accounting standards. Auditors have considerable expertise in accounting matters. Lending that expertise to FASB could result in "better accounting pronouncements.

A simple review of the data in Exhibits 3 and 4 is sufficient to refute a contention that auditing firms always advocate the positions of their financial institution clients. Client preference is clearly not a sole factor that determines an auditor's lobbying position..

Does client preference, however, have any impact on auditor lobbying positions? Some evidence indicates it does. Additional empirical research testing the theory that auditor lobbying is a function of client preference, audit risk, and wealth effect variables indicates these are significant explanatory components of auditor lobbying behavior, at least with respect to the seven identified issues in this study.5 In other words it has been found that client preference is, in fact, one of a number of factors affecting auditor lobbying.

We, therefore, agree with the POB's recommendation that ". . . [auditing] firms should take special care to ensure that their participation in the standard setting process is characterized by objectivity and professionalism."6 Further, we concur with the POB-appointed Advisory Panel on Auditor Independence, which recently said, "[I]t is essential that the [auditing] firm's internal organization and processes for developing . . . positions [for submission to standard-setting bodies] be insulated from undue pressure from or on behalf of clients. . . Client-related motivations, or even the appearance thereof, in reaching or communicating accounting policy decisions can contribute to a decline in the integrity, objectivity, and professionalism of public accounting firms and in public respect for the profession."7

This current research project has limitations that should be noted. Because the data gathered relates specifically to banks and S&Ls, research results can not be generalized to other industries. Also, the data set of matchable positions is relatively small, is restricted to written comments submitted to FASB, and the auditor data consist primarily of big eight responses.

* Associate Professor of Accounting, Cleveland State University

** Associate Professor of Accounting, Kent State University

*** Professor of Accounting, Kent State University

Address correspondence to: Professor Michael A. Pearson, College of Business Administration, Kent State University, Kent, Ohio 44242-0001, Phone: (330) 672-2545 ext. 376, Fax: (330) 672-2448, E-mail: mpearson O kentvm.kent.edu

1 Public Oversight Board of the SEC Practice Section of the American Institute of CPAs, Report of the Public Oversight Board on Issues Confronting the Acounting Profession (Stamford CT: 1993), p. 45.

2 Ernst & Whinney, Current Issues: Banks and Thrift Institutions (Cleveland OH: 1984).

3 A detailed description of each sub-issue is available from the authors upon request.

4 In addition to the matchable responses, the non-matchable responses were also analyzed. In most cases, the non-matchable respondents lobbied "in favor of and "against" sub-issues in proportions similar to the matchable respondents. In other words, the matchable responses fairly represent the non-matchable responses.

5 Heidi Hylton Meier, Pervaiz Alam, & Michael A. Pearson, "Auditor Lobbying for Accounting Standards: The Case of Banks and Savings and Loan Associations,' Accounting and Business Researh, Vol. 23 (Autumn 1993), pp. 477-87. See also Ross L. Watts & Jerold L. Zimmerman, Positive Accounting Theory(New York: Prentice Hall, 1986). 6 Public Oversight Board, loc. cit. 7 Advisory Panel on Auditor Independence, Report to the Public Ovesight Board of the SEC Practice Section, AICPA: Strengthening the Professionalism of the IndePendent Auditor (Stamford CT: 1994), p.11.

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