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The Accounting Debate:
Principles vs. Rules
By Art Berkowitz and Richard Rampell
December 2, 2002
 
 

Earl of Sandwich: 'Pon my honor, Wilkes, I don't know whether you'll die on the gallows or of the pox.

John Wilkes: That must depend, my Lord, upon whether I first embrace your Lordship's principles, or your Lordship's mistresses.

  * * *  

Rules vs. Principles . This is the heart of a current debate regarding how accountants should approach their role as validator of financial statements.

Today, rules drive the process. Relying exclusively on rules permits accountants to declare a financial statement has met the letter of the law, or regulation, even when the spirit of the law is being grossly defiled. Under a principles regime, accountants would be required to use their judgment to determine if various financial reporting tactics are kosher or not.

While the rules-based system seems firmly entrenched, the debate about a principles-based system is intensifying. The recently enacted Sarbanes-Oxley law requires the SEC to conduct a study on "the adoption by the United States financial reporting system of a principles-based accounting system" and to submit a report by July, 2003. The question for investors: Would a principles-based system give them more and better information, or would it lead to more of the accounting abuse like we've seen in the past 12 months?

Clearly the rules-based system has not worked well recently. The corporate landscape is littered with "legal" malfeasance. Much of the financial reporting shenanigans uncovered to date fell within the established rules, even if the rules were pushed against. By relying so intensely on rules, rather than principles, one reader says CPAs abdicated their responsibility to use their professional judgment.

In other words, form over substance, the letter vs. the spirit of the law. It's understandable why accountants have moved so hard to a rules-based system. The industry feels besieged by the securities plaintiffs lawyers and have sought refuge behind rules in a bid to find safe harbor from liability. According to FASB spokesperson Sheryl Thompson, the rules approach has been partly "driven by the trial bar ... [and] provides some protection."

Another reason for relying on rules stems from the "meeking" of the profession. Devotion to rules helps accountants avoid confrontations with clients. "It's not my judgment, it's the rules that tell us this is wrong." The slavish devotion to rules has led to a cottage industry in accounting machination. The big firms have concocted all kinds of slippery methods that enable companies to comply with the exact letter of the rules while still managing to mislead investors. Case in point: Enron and its multiple "special purpose entities," which allowed it to omit substantial liabilities from its balance sheets while staying within the rules of the accounting game.

But this pell-mell run to rules doesn't even dovetail with what the industry proclaims is the right way to do audit work. According to FASB's Ms. Thompson, following "the letter and spirit of the standard is key." [Emphasis added.] Or, as Harvey Pitt, of blessed memory, said to the SEC on March 21, 2002, "The development of rule-based accounting standards has resulted in the employment of financial engineering techniques designed solely to achieve accounting objectives rather than to achieve economic objectives."

Yet Lynn Turner, former chief accountant for the SEC, and one of the accounting profession's leading critics, is very skeptical about whether principle-based accounting will lead to improved quality in financial statements. After discussing the issue with representatives of the Senate Banking Committee, the International Accounting Standards Board (IASB), and the U.S. Financial Accounting Standards Board (FASB), we understand why Mr. Turner is skeptical.

A principle-based system of standards looks to a "timeless" body of accounting concepts for guidance. When should income and expenses be recognized? How should income be measured? What information should be reported in financial statements? For example, a fundamental concept in accounting is the "matching principle." Revenues are matched with the expenses incurred to earn those revenues and are to be reported in the same period. Proper matching keeps companies from reporting the revenue from a transaction in one period but reporting the expenses related to that revenue in a later period, thus inflating the net income in the earlier period. In theory, accounting principles would rarely, if ever, have exceptions, since the concepts would be evergreen and enduring.

But we heard otherwise from experts in the field.

In order to give financial statement users some semblance of comparability, and the regulators some means to enforce the standards, principle-based accounting would require that the rule writers include fences (or limits) in those standards. Therefore it would be necessary that exceptions (with examples) be built into the rules. In other words, principles-based accounting will still need quite a few rules that could be pushed against by aggressive financial engineers.

Here is an example of what we might see:

Principle: All entities that control another entity must consolidate the assets, liabilities, and equity of the other entity.

Purpose: Eliminate off-balance sheet items similar to what happened at Enron.

Exception: Any company that has between 18,000 and 20,000 employees, whose main office is located between latitude 20 degrees, 58 minutes and 20 degrees, 59 minutes north; and longitude 95 degrees, 21 minutes and 95 degrees, 22 minutes west are exempted from the provisions of this rule.

If you think we are kidding, you might want to check out the tax code. If the exceptions happen to apply only to a single company whose main headquarters happen to lie within the home district of the chairman of the committee, don't be too surprised. Such exceptions litter the tax code.

A rules-based system has been in partial effect at FASB due to the complexity of the standards, which cry out for "rule-driven implementation guidance" according to a recent FASB Proposal entitled Principles-Based Approach to U.S. Standard Setting. "Not only does detailed guidance provide the SEC with an effective enforcement mechanism ... auditors ... have indicated a need for detailed guidance because it limits the ability of the SEC and others to second-guess professional judgments." Derivatives and securitizations are examples mentioned in the Proposal.

Nevertheless, the law of unintended consequences applies here as well. "For example, some [rules] refer to situations in which complex structures or a series of transactions…are created to achieve desired accounting results -- for example, to remove assets from the balance sheet while retaining the overall economics of the assets, to recharacterize assets, or to improve cash flows from operations [an element of one of the financial statements]."

As a result, "lease vs. buy" decisions are made because of rules, rather than because of economics. Appreciated real estate, owned for a long period of time, may be sold to improve the cosmetics of a financial statement since the rules require real estate to be reported on the balance sheet at the lower of cost or market.

Critics of a principles-based approach argue that financial statements would likely lose their comparability and consistency across industries and issues regarding income measurement and recognition would remain controversial. For example, how much income will General Electric actually recognize on a multiyear defense contract under the percentage of completion method of accounting? Will this be comparable to the income reported by its competitors? And most importantly, will the auditors, many of whom have been caught behaving badly recently, abuse their trust and fail to apply the principles in "good faith consistent with the intent and spirit of the standards."

A principles-based system will require auditors to apply professional judgment in more circumstances, rather than less. Since they have often set low standards for themselves in this regard (even failing to meet those), it is a big question if they will rise to the occasion. In this case, investors should be grateful to the plaintiffs' bar.

We hope that the experts who are debating this change will be wise enough to reach a result that will benefit investors as well as the companies and professions they regulate. Along with the Sarbanes-Oxley requirements, the FASB plans to hold a public roundtable discussion on December 16, 2002. You can submit your own comments to them in writing by January 3, 2003, to directors@fasb.org . You can bet that the big firm accountants will weigh in (their motto could be "no attestation without representation"). But they should not dominate the discussion.

Converting rules to principles is not a simple task. Mr. Turner said, "The real issue is not simply one of broad versus narrow detailed rules. It is a cultural issue of a lack of compliance with both the spirit and intent of the standards. It is an issue of professionalism."

Stay tuned and let us know if you think that the accountants can be trusted to make professional judgments like in "the good ol' days." Or, must we give them a cookbook formula so investors will know the books are not being cooked?

 
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