As Groucho Marx once said, "Those are my principles, and if you don't like them...well, I have others."

Groucho would enjoy the heated stalemate over principles-based accounting. Four years after the Sarbanes-Oxley Act required the Securities and Exchange Commission to explore the feasibility of developing principles-based accounting standards in lieu of detailed rules, the move to such standards has gone exactly nowhere.

Broadly speaking, principles-based standards would be consistent, concise, and general, requiring CFOs to apply common sense rather than bright-lines. Instead of having, say, numerical thresholds to define when leases must be capitalized, a CFO could use his or her own judgment as to whether a company's interest was substantial enough to put a lease on the balance sheet. If anything, though, accounting and auditing standards have reached new levels of nitpickiness. "In the current environment, CFOs are second-guessed by auditors, who are then third-guessed by the Public Company Accounting Oversight Board [PCAOB], and then fourth- and fifth-guessed by the SEC and the plaintiffs' bar," says Colleen Cunningham, president and CEO of Financial Executives International (FEI).

Indeed, the Financial Accounting Standards Board seems to have taken a principled stand in favor of rule-creation. The Board continues to issue detailed rules and staff positions. Auditors have amped up their level of scrutiny, in many cases leading to a tripling of audit fees since 2002. And there is still scant mercy for anyone who breaks the rules: the annual number of restatements doubled to more than 1,000 between 2003 and 2005, thanks to pressure from auditors and the SEC. The agency pursued a record number of enforcement actions in the past three years, while shareholder lawsuits, many involving accounting practices, continued apace, claiming a record $7.6 billion in settlements last year and probably more in 2006.

Yet the dream won't die. On the contrary, principles are at the heart of FASB's latest thinking about changes to its basic accounting framework, as reflected in the "preliminary views" the board issued in July with the International Accounting Standards Board (IASB) as part of its plan to converge U.S. and international standards. Principles-based accounting has been championed by FASB chairman Robert Herz, SEC commissioner Paul Atkins, SEC deputy chief accountant Scott Taub, and PCAOB member Charlie Niemeier in various speeches over the past six months. And they're not just talking about editing a few lines in the rulebook.

"We need FASB, the SEC, the PCAOB, preparers, users, auditors, and the legal profession to get together and check their respective agendas at the door in order to collectively think through the obstacles," says Herz. "And if it turns out some of the obstacles are hardwired into our structure, then maybe we need some legal changes as well," such as safe harbors that would protect executives and auditors from having their judgments continually challenged. Even the SEC is talking about loosening up. Most at the agency favor the idea of principles instead of rules, says Taub, even knowing that "people will interpret them in different ways and we'll have to deal with it."

Standards Deviation
Why lawmakers are so set on principles and what exactly those principles would look like is all a bit hazy right now. "Post-Enron, the perception was that people were engineering around the accounting rules. We looked around the world and saw that England had principles-based accounting and they didn't have scandals there, so we decided this was the way to go," recounts CVS Corp. CFO David Rickard, a Financial Accounting Standards Advisory Committee (FASAC) member.

But Rickard considers the approach "naive." His firsthand experience with principles-based accounting, as a group controller for London-based Grand Metropolitan from 1991 to 1997, left him unimpressed. "We had accounting rules we could drive trucks through," he says.

Would such a change be worth the trouble? A recent study that compared the accrual quality of Canadian companies reporting under a relatively principles-based GAAP to that of U.S. companies reporting by the rules suggests that there may be no effective difference between the two systems. The authors, Queen's University (Ontario) professors Daniel B. Thornton and Erin Webster, found some evidence that the Canadian approach yields better results, but conclude that "stronger U.S. oversight and greater litigation risk" compensate for any differences.

U.S. GAAP is built on principles; they just happen to be buried under hundreds of rules. The SEC, in its 2003 report on principles-based accounting, labeled some standards as being either "rules" or "principles." (No surprise to CFOs, FAS 133, stock-option accounting, and lease accounting fall in the former category, while FAS 141 and 142 were illustrative of the latter.) The difference: principles offer only "a modicum" of implementation guidance and few scope exceptions or bright-lines.

For FASB, the move to principles-based accounting is part of a larger effort to organize the existing body of accounting literature, and to eliminate internal inconsistencies. "Right now, we have a pretty good conceptual framework, but the standards have often deviated from the concepts," says Herz. He envisions "a common framework" with the IASB, where "you take the concepts," such as how assets and liabilities should be measured, and "from those you draw key principles" for specific areas of accounting, like pensions and business combinations. In fact, that framework as it now stands would change corporate accounting's most elemental principle, that income essentially reflects the difference between revenues and expenses. Instead, income would depend more on changes in the value of assets and liabilities (see "Will Fair Value Fly?").

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