FASB Chairman Robert Herz advocates reducing accounting system complexity. He thinks some kind of national initiative may be required to get all the constituents to drop their own agenda and focus on achieving consensus. Do you agree?

[Reducing complexity] makes a lot of sense to me, and I agree whole-heartedly with Bob Herz that it is not just the standard setters that have to be involved. I know there is pressure to use details to fight litigation or [defend] against SEC questioning, but the complexity problem should be openly discussed. A conversation among multiple constituencies is something that will have to occur if we are going to pull this off.

Circling back to fair value, would adopting fair value help alleviate complexity in something as complicated as, say, derivative accounting (FAS 133)?

You have to understand that FAS 133 started off as an interim — perhaps political — step toward full fair valuing of financial instruments. If we had full fair value of financial instruments, many of the problems related to capturing the economics effects of change on companies — changes in interest rates, commodity prices, equity prices, foreign currency — would go away. But people weren't ready for, and probably still aren't ready for, full fair valuing yet. So FAS 133 is dealing with a partial fair valuing of a set of instruments that are being effected by interest rates, currencies, commodity, and equity prices.

So in a sense, FAS 133 was a stop-gap measure in response to the clamor over derivatives problems.

Yes, derivatives were causing huge losses in the mid-1990s, and nobody foreshadowed those losses. So to understand the degree of loss, or gain, occurring at companies that used derivatives, fair value was called for. Derivative accounting would not have been a big issue if full fair value for financial instruments was adopted at that point. But people weren't ready, so FASB had to build a hugely complex model to make derivatives losses — or gains — transparent, while trying to take out some of the measurement attribute mismatches.

What do you mean by mismatches?

That means only a half loaf gain or loss is represented. Let's say the company is exposed to interest rates, and it uses derivatives to hedge risk. As interest rates change during a period, the effects on the interest-risk item may not be transparent in that period's income statement if there is a mismatch in the timing of the recognition of interest-rate changes. The hedge accounting model says, if you can link a derivative to the interest-rate changes in a hedged item, and you document this in advance, you can [book] a change in the accounting so that the income statement effects of the derivative and the hedged item are in the same period, eliminating the mismatch.

And then you mitigate the effects on earnings?

You mitigate the one-sided effect on earnings. A concern of mine is that mitigating any effect on earnings does not reflect what is happening to the company [regarding] interest-rate changes — unless the company is perfectly hedged.

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