Demonstrate your understanding of the reasons for, and the structure of, the Financial Accounting Standards Board. Explain the impact of the Trueblood study on financial accounting standa

J. Account. Public Policy 34 (2015) 146–174

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J. Account. Public Policy

journal homepage: www.elsevier .com/locate/ jaccpubpol

The Wheat Study on Establishment of Accounting Principles (1971–72): A historical study

http://dx.doi.org/10.1016/j.jaccpubpol.2014.12.004 0278-4254/� 2015 Elsevier Inc. All rights reserved.

⇑ Tel.: +1 713 348 6066; fax: +1 713 348 6296. E-mail address: [email protected]

1 The report is accessible online at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDo C%2FDocumentPage&cid=1176156777828.

Stephen A. Zeff ⇑ Jesse H. Jones Graduate School of Business, Rice University, 6100 Main Street, Houston, TX 77005, United States

a b s t r a c t

The 1972 report of the Wheat Study on Establishment of Account- ing Principles became the blueprint for the Financial Accounting Standards Board (FASB), which began its official operations on July 1, 1973, succeeding the Accounting Principles Board. The FASB was the world’s first independent, full-time standard-setting board which was not organized within the accounting profession. This paper is an attempt to understand the crisis in standard setting that led up to the appointment of the Wheat Study, as well as the main elements in the Study’s process of examining the milieu of the APB, securing views from a wide range of interested parties, and fashioning its report, including the roles played by the differ- ent members of the study group.

� 2015 Elsevier Inc. All rights reserved.

1. Introduction

The aim of this paper is to come to understand the circumstances which led to the establishment in 1972 of the Financial Accounting Standards Board (FASB), which was the world’s first independent, full-time accounting standard setter. The paper examines the run-up to the appointment by the Amer- ican Institute of Certified Public Accountants (AICPA) of the Wheat Study on Establishment of Account- ing Principles in 1971 and the study group’s conduct of its inquiry and the development of the recommendations in its report, Establishing Financial Accounting Standards (1972).1 This paper is

cument_

S.A. Zeff / J. Account. Public Policy 34 (2015) 146–174 147

based on published and unpublished materials and an interview with the lone surviving member of the study group.

The paper unfolds by discussing the sequence of controversial and widely criticized pronounce- ments issued by the Accounting Principles Board (APB) from 1967 to 1970, followed by the AICPA’s decision to deal with this ‘‘crisis of confidence’’ by appointing two study groups: one to look into a bet- ter way of establishing accounting principles, and another study group to propound a set of objectives of financial statements. The remainder of the paper examines the selection of the members of the first of these two study groups, the organization of its work, the results of its public hearing, the develop- ment of the recommendations in its report, and, finally, the swift acceptance and implementation of the recommendations by the AICPA.

2. The crisis over the establishment of accounting principles that led to the appointment of the Wheat Study

Under pressure from the Securities and Exchange Commission (SEC) to make the difficult decisions to rid GAAP of alternative practices (Zeff, 2007a, pp. 14–21), the part-time APB, which was a senior technical committee of the AICPA, had its busiest and most contentious period from 1967 to 1970. During that span, it barely approved Opinion 11 on income tax allocation by the required two-thirds majority, 12 to 6, which was followed by an omnibus Opinion and then by Opinion 13, making Opinion 9, on reporting the results of operations, applicable to commercial banks. Opinion 14, with four dis- sents, was issued in March 1969, which declared that none of the proceeds from the issuance of con- vertible debt securities should be accounted for as attributable to the conversion feature, which overturned a provision in Opinion 10. Then, in the highly criticized Opinion 15, the board at some length and in considerable detail, with three dissenting members, prescribed how to calculate primary and fully diluted earnings per share, with a 30-page appendix of ‘‘computational guidelines,’’ and to define ‘‘residual securities,’’ a term introduced in Opinion 9. Two leading practitioners criticized Opin- ion 15 for being a ‘‘cookbook’’ of detailed rules, and a leading accounting academic also chimed in about the amount of detail in the Opinion (Hicks, 1969, p. 60; Tietjen, 1970, p. 10; Paton, 1971, p. 42). Another accounting academic, also editor of an accounting newsletter aimed at financial analysts, criticized Opinion 15 as being ‘‘a completely arbitrary pronouncement’’ (Seidler, 1972, p. 90).

The 1960s were a significant decade for mergers and acquisitions, many of which gave rise to con- glomerate and multinational corporations, when company executives began to view the level and trend of their reported earnings as a strategic weapon in their arsenal either to engineer takeovers or to defend against them. Also in the 1960s, the rise of ‘‘opinion shopping’’ by companies pitted accounting firms against one another, as companies sought a lower audit fee and a more conciliatory attitude on the part of the firm toward their interpretation of permissible accounting principles. More- over, criticism of the accounting profession was on the rise in the wake of a number of financial scan- dals where pointed questions were being raised about the performance of the auditors (Zeff, 2003, p. 196; Lyons, 1966).

The decade culminated in the APB’s lengthy and anguished deliberations amid mounting and inces- sant pressures from industry and government on the subject of accounting for business combinations and goodwill. As board members heard from constituents (and as the partner members of the board heard from their clients), the board, in a series of backtracking moves, maneuvered from an initial position to drop the ‘‘pooling of interests’’ method altogether to, finally at the eleventh hour, allowing the method to survive if a merger were to satisfy a dozen tightly constrained attributes. The board’s twists and turns were widely reported in the nation’s press. The Financial Executives Institute (FEI), the influential organization of preparers, mounted a national press campaign to lobby against the dropping of pooling of interests. In the end, the APB’s vote on Opinion 16 on business combinations was by the required two-thirds majority, 12 to 6. In the vortex of outside pressures, including from the SEC, the board agreed that both Opinions 16 and 17 – on business combinations and intangible assets – had to pass, or both would fail, thus inviting the SEC to issue rules to fill the vacuum. One APB member, George R. Catlett of Arthur Andersen & Co., who firmly opposed the pooling of interests method, saw that six dissenters had already registered their votes. His seventh dissent would doom

148 S.A. Zeff / J. Account. Public Policy 34 (2015) 146–174

Opinion 16. Therefore, biting hard, he assented to the Opinion so that both pronouncements would pass. Opinion 17 on intangible assets, also contentious, passed by a one-vote margin, 13 to 5. None of the board members were satisfied with the compromises required to approve the two Opinions, both of which were issued in August 1970 (Zeff, 1972, pp. 212–216; Chatov, 1975, chaps. 13 and 14; Seligman, 2003, pp. 419–430). Leonard Spacek, the managing partner of Arthur Andersen & Co., said, ‘‘There is no question in my mind that Opinions 16 and 17 create unjustifiable harm and damage and that they do not properly state the facts [of acquisitions and mergers]’’ (1970, p. 69).

On the 12 substantive, single-issue Opinions which the APB issued from 1962 to 1970, there was a total of 35 dissents. Eleven of them related to the same issue, the investment credit in Opinions 2 and 4, issued in early 1960s. Twenty-four of the dissents were cast in the five major Opinions discussed above (11, 14, 15, 16, and 17), which were issued between 1967 and 1970 (Zeff, 1984, p. 463). The con- tentiousness of these recent pronouncements by the APB was clearly evident in this gauge of discord within the board.

Tempers in several of the Big Eight accounting firms, which were rising since the issuance of Opin- ion 11 on tax allocation in December 1967, reached fever pitch after Opinions 16 and 17 came out. In 1969, Robert M. Trueblood, a senior partner in Touche Ross & Co., a former APB member and former Institute president, complained that, because of the APB’s lack of a basic philosophy of accounting, it had lost its effectiveness, and he proposed that it be restructured as a full-time body (1969, pp. 6–7). Academics were critical, too. In August 1970, the American Accounting Association (AAA) created a special committee (known as Committee 42) ‘‘to study the feasibility and desirability of a commission to inquire into the formulation of accounting principles’’ (The Role of the American Accounting Association. . ., 1971, p. 609). On January 8, 1971, the committee, chaired by David Solomons, submit- ted its report in which it unanimously recommended the creation of such a commission. The AAA’s executive committee decided unanimously in February 1971 to endorse the committee’s report. The AICPA’s leadership, for its part, was furious that the AAA, an association run by academics, should tread on the Institute’s turf, for it was an Institute committee and then board that, since 1939, had been issuing opinions on what constitutes GAAP. The leadership made its annoyance known in unmis- takable terms to the then AAA president, James Don Edwards (Edwards, 2010, pp. 188–189).

The tide changed profoundly within a two-week period in November 1970. The senior partners of three of the Big Eight firms – Arthur Young & Company, Touche Ross & Co., and Arthur Andersen & Co. – wrote letters of great concern to the AICPA leadership. Ralph E. Kent of Arthur Young and Robert Trueblood of Touche Ross both referred to the charge given to the AAA committee and recommended that the Institute sponsor a re-examination of, or a commission to look into, how accounting principles should be established. Kent and Trueblood were past presidents of the Institute, and Trueblood had served on the APB. They focused in particular on APB Opinions 16 and 17, but their concerns were broader and, for Trueblood, went back several years. Trueblood referred to ‘‘the long, difficult, and embarrassing history’’ of the two Opinions. Kent referred to ‘‘the long drawn out battle to issue’’ them, ‘‘including shifting positions and threats of legal action’’ as well as ‘‘the not-infrequent public criticism of the Board by members of the Institute, by academicians, by analysts, by corporate executives.’’ Trueblood said that his firm was ‘‘presently reconsidering our entire participation in the affairs of the [APB].’’ Harvey E. Kapnick, Jr. of Arthur Andersen, while not referring to the AAA committee, also argued that the Institute should make a number of necessary changes in the APB’s organization and operations. In a letter that was longer than Trueblood’s and Kent’s combined, Kapnick wrote, ‘‘Most of the [APB’s] pronouncements represent little more than detailed, arbitrary rules, which set forth almost no reasoning as to how and why they meet the needs of investors and other users of financial statements.’’ He also argued that the lack of agreement on what should be the objectives of financial statements had impeded the APB’s effectiveness. Ominously, Kapnick wrote, ‘‘the situation [with the APB] is rapidly deteriorating, and it may no longer be desirable for the AICPA as a whole to continue to rely upon the APB as it is presently constituted. Likewise, it may no longer be reasonable to expect AICPA members to do so.’’ He said that his firm favored a board composed of five to seven full-time members.

John C. Biegler, the senior partner of Price Waterhouse & Co., subsequently characterized the tem- per of the times by the end of the 1960s, when, he said, the APB was rapidly losing its credibility as a standard setter:

S.A. Zeff / J. Account. Public Policy 34 (2015) 146–174 149

The late ’60s were turbulent times for the accounting profession and those activities closely iden- tified with it, such as the APB. The financial press seemed to be discovering accounting and the accounting profession for the first time. It was a time of ‘‘creative’’ accounting practices which helped fuel the new issues and mergers boom, and it was a time of ‘‘shopping around’’ among accounting firms for more and more innovative applications of existing accounting techniques. At the same time the public was beginning to hear on a regular basis news of lawsuits being filed against accounting firms and to read to its dismay about some fairly spectacular business failures alleged to have had their roots, at least in part, to inadequate accounting standards in general, and inadequate financial disclosures and auditing performance in particular. . .. Adding fuel to the fire was a constant drumbeat of heavy criticism of the profession and of the work of the APB from highly vocal sources within the profession itself (1983, p. 4).

One concern that motivated Robert Trueblood and perhaps also some other critics of the APB was the recent Continental Vending decision,2 where the federal Court of Appeals for the Second Circuit ruled that the auditor’s judgment about what constitutes GAAP does not in itself imply that the financial statements ‘‘present fairly.’’ This meant to Trueblood that the standing of GAAP was on the decline.3

Within the same two-week period – from November 11 to 24, 1970 – the APB’s five-member com- mittee on board operations, headed by APB Chairman Philip L. Defliese, of the Big Eight firm of Lybrand, Ross Bros. & Montgomery, submitted its report on the APB’s operations in a letter to the Insti- tute’s board of directors.4 While expressing satisfaction with the APB’s structure and operations, the committee conceded that ‘‘its reputation with the general public is probably at a low point at present,’’ due to the board’s handling of Opinions 16 and 17. It added, ‘‘Notwithstanding its confidence in the via- bility of its present structure, the APB believes that the time may be ripe for an independent, objective investigation of the entire question of the establishing of accounting principles.’’5 Because all of the Big Eight firms were represented on the APB, this meant that all or most of the big firms were in support of such an inquiry. The report recommended a full-time chairman, greater technical support and research capability, and retention of the two-thirds vote.

SEC Commissioner James J. Needham, the first practicing CPA ever to be named to the Commission, added pressure of his own. He met in October with Leonard M. Savoie, the Institute’s executive vice- president, to convey his disappointment at the APB’s inability to resolve accounting problems quickly. He said that the SEC is considering the issuance of Accounting Series Releases on important accounting matters and wanted to know the APB’s reaction to such a move.6 Further, he attended a meeting of the Institute’s committee on relations with the SEC and stock exchanges on November 5. Needham’s com- ments were alluded to as one of a number of concerns about the viability of the APB in Ralph Kent’s let- ter, discussed above. The gist of what Needham said was reported in the press: that, if accounting leaders did not take action to repair the process of establishing GAAP, the Commission would (Andrews, 1972).7

Institute President Marshall S. Armstrong, a partner in a middle-tier Midwestern firm, realized that he had a crisis on his hands. After consulting with the Institute’s board of directors, he immediately called a Conference on Establishment of Accounting Principles to be held on January 7–8, 1971 at the Watergate Hotel in Washington, DC, inviting 35 prominent CPAs representing 21 large and mid- dle-sized accounting firms, to discuss the Institute’s future course with respect to pronouncing on accounting principles. In his letter, he posed nine searching questions to be addressed and said that the aim of the meeting was to ‘‘unite the accounting profession in reexamining how accounting prin- ciples should be established.’’ He said that ‘‘It is envisioned that the discussion would lead, as soon as possible, to the submission of a report with recommendations to the Institute’s Board of Directors,’’ whose next meeting was set for February 25–26. One of the attachments to his letter was the charge to the AAA’s Committee 42.

2 United States v. Simon, 425 F.2d 796 (2d Cir. 1969). 3 Interview with George H. Sorter, August 13, 2014. 4 In this paper, ‘‘chairman’’ is used because this is the form of noun used in all of the cited documentation. 5 These four letters are in the author’s files. Three of these four letters were referred to in a press report (Heinemann, 1972). The

letter from Arthur Andersen & Co. was reproduced in AICPA Study on Establishment of Accounting Principles (1972, pp. 319–326). 6 Minutes of meeting of the Accounting Principles Board, October 21–23, 1970 in New York City, p. 4 (in the author’s files). 7 The minutes of this committee meeting, if any were taken, have not survived.

150 S.A. Zeff / J. Account. Public Policy 34 (2015) 146–174

It is interesting that only the AICPA members who were partners in accounting firms were invited to this pivotal meeting. The Institute’s leadership did not feel it was necessary to consult others than partners in firms. To the leadership, it would seem, ‘‘the profession’’ still meant the members in accounting firms. The dominant composition of the APB also reflected this view. Since its beginning in 1959 and until January 1, 1971, the APB’s 59 members included the Institute’s research director, an accountant in government, seven corporate financial executives, eight accounting academics, and one financial analyst, all of whom had to be CPAs and also members of the Institute (Zeff, 2007b).8

The other 41 APB members were partners in accounting firms, and at all times they constituted a major- ity of the board’s membership.

After nearly ten hours of discussion, the conference ‘‘adopted a resolution strongly urging the AICPA president to appoint two study groups, acting independently of one another, to explore ways of improving the Institute’s function of establishing standards of financial reporting.’’9 The first study group, it said, ‘‘should review the operations of the Accounting Principles Board, and the second should seek to refine the objectives of financial statements.’’ It is noteworthy that the conference ‘‘emphasized that each group should include significant representation from outside the practice of public accounting’’ (Conference on Accounting Principles, 1971, p. 2).

Armstrong’s determination to find an Institute solution was redoubled when Robert Trueblood informed him that, if the Institute did not act decisively, he was prepared to support the formation of the commission envisioned by AAA Committee 42 in its January 8th report.10

Armstrong thereupon submitted the conference’s resolution to the Institute’s board of directors, which promptly approved the setting up of the two study groups. The one on objectives, to be chaired by Robert Trueblood, is discussed in Zeff (2014). The one on establishing accounting principles, to be chaired by Francis M. Wheat, is the subject of this paper.

3. Selection of the members of the Study

For the chairman of the seven-member Study, Institute President Armstrong placed a safe bet by selecting a former SEC Commissioner. Of course, the SEC would have to endorse – or at least not be unhappy with – any new approach to establishing principles, because it had, since 1939, been defer- ring to the organized accounting profession when deciding on the GAAP acceptable to the Commis- sion. Frank Wheat was a Commissioner from 1964 to 1969, a Democrat who was appointed by President Lyndon B. Johnson. He was best known for directing the SEC’s major review of its disclosure policies, in 1969, known as the Wheat Report (Disclosure to Investors, 1969), thus ‘‘establishing a rep- utation as a reformer on financial reporting procedures’’ (The Man Behind CPA Study, 1972, p. 73). His report led to extensive changes in the SEC’s disclosure regulations (SEC Makes Sweeping Changes in Disclosure Regulations, 1970). Wheat was a partner in the Los Angeles law firm of Gibson, Dunn & Crutcher.

Three of the other members were senior partners in major public accounting firms: John Biegler, the senior partner of Price Waterhouse & Co., New York City; Wallace E. Olson, executive partner of Alexander Grant & Company, Chicago; and Arnold I. Levine, national executive partner, management of J.K. Lasser & Co., New York City. Of the three, only Biegler had served on the APB, from 1966 to 1968. Biegler’s firm ‘‘was considered by many to be the intellectual leader of the auditing profession’’ (Wise, 1982, p. 66). Olson was a member of the Institute’s Council, and Biegler was on the Institute’s board of directors and thus also a member of Council.

Because of the reputation of General Motors Corporation (GM) for the high quality of its financial reporting, it was believed to be important to have GM represented on the Study,11 and an approach

8 In this source, Biegler’s name is miswritten as John P. Biegler. The number given by the Study for the APB’s membership from 1959 to the beginning of 1972 of five chairmen plus 63 other members should read 63 members, including five chairmen (Establishing Financial Accounting Standards, 1972, p. 26).

9 Of interest is the shift in wording from ‘‘establishing accounting principles’’ to ‘‘establishing standards of financial reporting,’’ the latter suggesting a broader scope.

10 Interview with George H. Sorter, August 13, 2014. 11 Interview with Thomas C. Pryor, June 21, 2014.

S.A. Zeff / J. Account. Public Policy 34 (2015) 146–174 151

was made to the company. Thomas A. Murphy, GM’s executive vice-president and former corporate comp- troller, who in recent years had become an active member of the Financial Executives Institute’s (FEI’s) committee on corporate reporting, asked Roger B. Smith, GM’s vice president-finance, to accept a position on the study group, which he did (Flegm, 2002, p. ix). Smith therefore became the delegate of the FEI, the highly influential body of financial executives. He was an accounting graduate of the University of Mich- igan and had studied under Professor William A. Paton, whom he admired. Smith was later to become a severe critic of the FASB, and in 1981 he became GM’s chairman and chief executive.

Thomas C. Pryor, CFA, a partner and chairman of the investment committee of the investment banking firm of White, Weld & Co., New York City, was tapped from the financial community. He was a former director of the Financial Analysts Federation (FAF) and was then serving on its financial accounting policy committee. He recalls that his selection, orchestrated by Leonard Savoie, the AICPA’s executive vice-president, stemmed from his role in drafting a resolution for the FAF in 1964 that rec- ommended against the use of ‘‘cash earnings per share’’ in analytical reports on companies. Such an earnings per share figure was the bête noire of the Institute and of the APB,12 and the position which the directors of the FAF espoused, in approving the resolution, was much appreciated within the Institute’s leadership.13 Savoie, who was at that previous time a partner in Price Waterhouse, knew that Pryor had drafted the FAF resolution, and that led, Pryor thinks, to his appointment to the Study.14

Finally, David Solomons, an accounting professor and chairman of the department, The Wharton School of the University of Pennsylvania, Philadelphia, was chosen as the academic member. He had chaired the AAA’s Committee 42 and was the AAA’s director of research from 1968 to 1970. Solomons was an English chartered accountant and came to the United States in 1959. He became the principal draftsman of the Study’s report, in contrast to the Trueblood Study Group, whose consid- erable full-time staff did all of the drafting (The Man Behind CPA Study, 1972, p. 74; Zeff, 2014).

It is interesting to note that only three of the seven members of the Study were practicing CPAs. When composing the study group, the Institute took seriously the advice from the conference, namely, ‘‘to include significant representation from outside the practice of public accounting.’’15

Michael A. Pinto, who was Leonard Savoie’s executive assistant, was deputized to serve the Study as administrative secretary.

By the time the author began this research project, in June 2014, all but one of the Study’s mem- bers, as well as Armstrong, Savoie, and Pinto, were deceased. The author interviewed Thomas Pryor by telephone to acquire some insights into the dynamic of the study group’s work.

4. The charge to the Study

On March 29, 1971, the Institute conveyed its charge to the Study on Establishment of Accounting Principles, or Wheat Study as it came to be called. It said that

The main purpose of the study is to find ways for the American Institute of Certified Public Accoun- tants to improve its function of establishing accounting principles. . .. The study should examine the organization and operation of the Accounting Principles Board and determine what changes are necessary to attain better results faster. This will involve study, for example, of all the many changes that have been suggested, ranging from minor procedural suggestions to complete replacement of the part-time volunteer Board by a full-time paid Board with a court-like appeal

12 See the criticism of the mis-use of ‘‘cash flow’’ and ‘‘cash earnings’’ in Mason (1961, pp. 38–39) and in an editorial in The Journal of Accountancy (APB Opinion on ‘‘Cash Flow,’’ 1963). APB Opinion 3, issued in October 1963, recommended against the use of ‘‘cash earnings’’ and ‘‘cash flow per share’’ (paragraph 15). The title of Opinion 3 was The Statement of Source and Application of Funds.

13 For an editorial in The Journal of Accountancy welcoming the resolution, see Not to Mislead the Public (1964). For the resolution, with an introduction by Pryor, see Funds Analysis. . . (1964).

14 Interviews with Thomas C. Pryor, June 21 and 27, 2014. 15 This desire to have a diverse membership of the Study seems to have had repercussions elsewhere in the Institute’s

organization. In 1971, for the first time, a company executive was brought onto the board of directors, whose membership was previously limited to partners in accounting firms and one academic. In 1972, a representative from the financial community was appointed to the board of directors.

152 S.A. Zeff /

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