Peeling away financial reporting issues one layer at a time

The Myth of FASB Due Process: And the Fact of Undue Influence

When the FASB announced last month that it was retreating from its proposal to require fair value measurement of all loans, someone identified by various media outlets as an FASB spokesperson (one Neal McGarity, whose name is not listed among the FASB’s staff), gratuitously remarked, “The vote today is a reflection of our due process at work and how important input from our constituents is in decision making.”

As you can imagine, that’s not exactly how I would describe the series of events that redirected the FASB from nigh onto true north on financial instruments accounting back to yet another recipe for random number generation: the orchestrated form letter campaign from irate bankers; the firing (I strongly suspect) of the FASB chairman (a staunch proponent of fair value); and the appointment of three new board members, who could be reliably counted on to vote as I believe FAF chair John Brennan clearly wished them to.

McGarity’s comment was the motivation for my own characterization of an FASB “operating behind the façade of democracy and due process,” which in turn led to a lengthy comment from the venerable Edith Orenstein of the FEI Financial Reporting Blog:

“Due process can be difficult to examine, and one question to consider is whether a flood of identical comment letters (aka to some people ‘form letters’) should necessarily be discounted. I personally don’t think so. If a point is generally agreed upon by tens, hundreds, or thousands of companies (or investors) I do not believe their choice of using an efficient means of communicating their views, even if the template was developed by a member of a business advocacy group — or — an investor advocacy group — should color the substance of the view expressed, nor should the sheer quantity of responses be discounted just because they arrive as ‘form letters.’ Importantly, it is the quality of comment letters (‘form letter’ or not) that should be paramount, in addition to the quantity of comment letters – quantity, for whatever it’s worth, is how democracy is determined.”

I’ll respectfully respond to Edith, but after I make a couple of general observations about due process.

What is FASB Due Process, Anyway?

The term “due process” is obviously much older than the FASB, or even GAAP. Wikipedia describes it as:

“… the principle that the government must respect all of the legal rights that are owed to a person according to the law. Due process holds the government subservient to the law of the land protecting individual persons from the state. When a government harms a person, without following the exact course of the law, then that is a due process violation which offends the rule of law.”

All of the other websites I looked at provided similar explanations, which doesn’t even remotely describe what the FASB says it is supposed to be doing.

So the first point I want to make is that “due process” as a description of the FASB’s policies is a misnomer. The FASB’s use (along with that of the monkey-see-monkey-do IASB) of the term is merely another instance of its tactical use of weasel words and phrases to cast an aura of gravitas on a process without having to actually specify that process in any significant detail. Of course, the guarantees of due process in law are highly specified, even though they may be intensely debated. Among other things, they consist of the right to a full and fair trial, governed by rules of evidence, impartiality, burden of proof, etc.

There are no real rules for due process at the FASB, like we see in the law: rules of evidence, decision criteria, etc. All we are provided by the FASB’s Rules of Procedure (page 5) are vague statements that pretty much allow the FASB to do what it wants, when it wants. Maybe a new standard will be evidenced-based, or maybe it won’t. Maybe a new standard will be consistent with the concepts statements (although those are also like nailing jell-o to a tree), or maybe it won’t.

And, in case you’re wondering, the term due process is nowhere to be found in the securities laws or in the way the SEC, the main source of the FASB’s legitimacy, describes its own rulemaking activities.  The SEC simply states that “the Commissioners consider what they have learned from the public exposure of the proposed rule, and seek to agree on the specifics of a final rule.” In other words, SEC evaluation of public comments is not part of a “due process” (or a democratic process) but simply purports to be a learning process.

If Not Due Process, Then What Process?

Actually, I wrote about that here, two years ago:

I have given some thought as to why … very few [investors] submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one’s core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

… The policy implication is that, instead of pining for more comment letters from investors, the FASB … should acknowledge the free rider problem in their ‘due process’ deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense …. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.

And last year, here:

The Board [should consider] the feedback from non-investor stakeholders – principally auditors, preparers, attorneys and other finance professionals – to the extent that such feedback provides relevant information regarding cost and feasibility of a proposed change to standards. However, the evaluation of a proposed standard’s effect on relevance and reliability, [should] be made independent of feedback from non-investor stakeholders.

What the FASB should be doing to evaluate rule changes would be much more aptly described by the term “due diligence” instead of due process. According to Wikipedia, “due diligence” has its origins in the Securities Act of 1933, but has spread to many other applications. The main point, though, is that due diligence connotes comprehensiveness, rigor and reason. I readily grant that the FASB has numerous stakeholders, but (Neal McGarity take heed) the FASB has only one constituency, investors. Therefore, due diligence must involve giving due consideration to investors.

Dear Edith

That brings me to two specific responses to my friend, Edith Orenstein.

First, and as Edith correctly observes in a blog post of her own, the application of a due process concept to standard setting is squishy – but that’s the intention. Due process at the FASB is a façade for allowing the Accounting Establishment to call the tune at the FASB. It’s not just the big corporations and their trade associations cum lobbyists. The FASB is just not set up to function without the bodies that the Big Four lends to it. Of course, the quid pro quo is influence that goes well beyond their comment letters and those of their clients.

Due consideration of investor input implies that the FASB should not be unduly influenced by the Accounting Establishment, but it is in virtually everything it does. There is pressure on the Financial Accounting Foundation to appoint the right members; and the staff of the FASB and the members of the EITF are stacked with Big Four members.

Second, effective rulemaking needs to consider not only the content of a comment letter, but who wrote it. Unlike a democracy, though, some of the FASB’s stakeholders should be treated more equally than others.


  1. Reply Sharmus Fulkeywey February 23, 2011

    Neil McGarity is a FAF employee and reports to Terry Polley and Grace Hinchman. My understanding is that “due process” is meant to follow the procedures of the Federal rulemaking process embodied in the Administrative Procedures Act.

  2. Reply Bradley August 5, 2011

    This is just the thing I needed for my research papers. Thanks a ton. Now my paper has all the matter it required.

Leave a Comment