Putting the Dimmer on Bright Lines

Members of an SEC committee believe eliminating threshold tests will help their goal of allowing more judgment in financial reporting.
Sarah JohnsonMay 5, 2008

The Securities and Exchange Commission’s advisory committee plans to erase the so-called bright lines in accounting.

Its Committee on Improvements to Financial Reporting (CIFR) believes that “GAAP should be based on a presumption that bright lines should not exist,” according to a report put together by one of its subcommittees. The group members have not yet voted on this recommendation, which could be submitted as part of a second round of suggestions for simplifying financial reporting due to the SEC this summer.

Assuming the committee does keep much of the same language for the SEC’s consideration, it will be asking the regulator to encourage the Financial Accounting Standards Board to not use bright lines in future standards. And that would make good on the movement to move the U.S. to more principles-based accounting that allows more judgment.

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CIFR is suggesting that companies instead use “proportionate recognition” or additional disclosures when making accounting decisions that currently call for a bright-line test. In the area of lease accounting, for example, when a company needs to record its rights and obligations of a leasing contract — and figure out whether it needs to record that asset on its balance sheet — its accountants would think about how much right they have to an asset, rather than considering the asset’s worth.

The committee gives the example of a leased machine worth $100 that has a four-year contract and should last for 10 years. Under current rules, the lessee would use bright-line tests and decide to either record $100 on its balance sheet or record nothing. But by using CIFR’s preferred method of proportionate recognition, the lessee would put about $35 on its balance sheet as a calculation for its right to use the machine.

The issue is particularly pertinent following the subprime-mortgage problems where banks’ use of off-balance sheet treatment for securitized transactions have come into question.

“Are we better off going to a framework that is more proportional so it isn’t [about] a light switch you turn on and off when recognizing a capital lease or for a securitization where you’re managing the securitization and you’re going to provide all the liquidity when it gets into trouble?” asked Susan Bies, a CIFR member and former member of the Federal Reserve Systems’ board of governors, during a roundtable on Friday. In that case, “should you just go ahead and recognize it proportionally all the time, and not only when it hits bottom and you’ve got to come in and save the structure?”

It is widely accepted among accounting circles that percentage tests, strict thresholds, and numerical parameters in rules can lead companies to inappropriately use them to their advantage. “Bright lines cause complexity and structuring opportunities,” said Brooke Richards, vice president of global accounting in American Express, during the roundtable.

At the same time, there’s still a demand for bright lines by financial-statement preparers who are legitimately confused about what standard-setters and regulators expect. They give preparers a sense of the principles that went into the thinking behind an accounting standard, according to Linda Bergen, a Citigroup vice president in the bank’s corporate accounting policy group.

They’re useful in determining whether a company should use the equity method of accounting after figuring out its significant influence over an investment, for example (currently, a company would do so if it has 20 percent or more ownership). CIFR’s idea of using proportional recording could cause more confusion without the use of threshold numbers, Bergen implied.

To be sure, for CIFR, the key to this particular recommendation is whether it will actually lead to simplified financial reporting. Its members claim that as it is, bright lines have forced standard-setters and regulators to come up with guidance on top of guidance just to dissuade structured transactions made possible by definitive rules.

Another argument in CIFR’s favor is the move toward more principles-based accounting, which some accounting experts believes is more inherent in international rules than the ones promulgated by FASB. CIFR will consider asking the SEC to acknowledge the International Accounting Standards Board’s work in having fewer bright lines in their accounting literature than U.S. GAAP.