Accounting & Tax

Standing on Principles

In a world with more regulation than ever, can the accounting rulebook be thrown away?
Alix StuartSeptember 1, 2006

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).

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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?“).

For its part, the SEC has also made clear that it does not envisage an entirely free-form world. “Clearly, the standard setters should provide some implementation guidance as a part of a newly issued standard,” its 2003 report states.

The catch is that drawing a line between rules and principles is easier said than done. Principles need to be coupled with implementation guidance, which is more of an art than a science, says Ben Neuhausen, national director of accounting for BDO Seidman. That ambiguity may explain why finance executives are so divided on support for this concept. Forty-seven percent of the executives surveyed by CFO say they are in favor of a shift to principles, another 25 percent are unsure of its merits, and 17 percent are unfamiliar with the whole idea. Only 10 percent oppose it outright, largely out of concern that it would be too difficult to determine which judgments would pass muster.

A Road to Hell?

As it stands now, many CFOs fear that principles-based accounting would quickly lead to court. “The big concern is that we make a legitimate judgment based on the facts as we understand them, in the spirit of trying to comply, and that plaintiffs’ attorneys come along later with an expert accountant who says, ‘I wouldn’t have done it that way,’ and aha! — lawsuit! — several billion dollars, please,” says Rickard.

Massive shareholder lawsuits were a concern for 36 percent of CFOs who oppose ditching rules, according to CFO’s survey, and regulators are sympathetic. “There are institutional and behavioral issues, and they’re much broader than FASB or even the SEC,” says Herz, citing “the focus on short-term earnings, and the whole kabuki dance around quarterly guidance.”

Other obstacles abound. It’s not clear, for instance, who should take the plunge first — or if anyone can take that step alone. “FASB can’t keep coming up with answers for everything,” says Dennis Beresford, the Board’s chairman from 1987 to 1997 and now an accounting professor at the University of Georgia’s business school.

The biggest source of new guidance in the past few years has taken the form of FASB staff positions. Since 2003, some 40 such documents have been issued, including 17 in 2005 alone. Many of them, says Beresford, are so narrow that “it’s hard to even understand the title, let alone how to apply it.” And nearly everyone agrees that some are superfluous. The broader fundamental FASB standards also show little evidence of a tight rein on rules. The business-combinations draft, at a hefty 236 electronic pages, is one example of the continued love affair with rules, says FEI’s Cunningham.

FASB’s Herz argues that the Board is only responding to the requests of neurotic auditors and CFOs, as well as references from the SEC staff. “It’s not usually to our liking, but we’ve had to — I’d say clarify, but really, it’s tell — people that yes, they can do this in this commonsense area, because they fear if they don’t have it in the accounting literature, they’ll be second-guessed,” says Herz. He says FASB responds only to repeat issues that would affect many companies. And FASB’s practice of soliciting opinions from all sides — generally considered a plus — is part of what leads to the lengthy rules in the first place.

CFOs blame the auditors. Of those opposing principles-based accounting, 45 percent say they do so because auditors are too conservative, making it too hard to come to an agreement, according to CFO’s survey. “After what happened to Arthur Andersen, risk mitigation seems to be the auditors’ biggest concern,” says Lyondell Chemical controller Charles Hall.

When it comes to the SEC, CFOs and auditors are united in saying that overzealous scrutiny would make a more subjective system unattractive, notwithstanding acting chief accountant Taub’s reassurances that he himself will be reasonable. “It’s one thing for the chief accountant to say, ‘We accept a principles-based world. It’s another thing for that to trickle down to the junior staff,” says Neuhausen. Notes Rickard: “If principles-based accounting is going to work, we need to be presumed to be right.” That would be a change from his past experience. Earlier this year, Rickard lost his controller and treasurer after the SEC opened an investigation into how the $38 billion company accounted for a $55 million barter transaction back in 2000.

The SEC, of course, says it is only doing its job. “I will admit that the SEC staff does believe that bright-lines in the standards ought to be respected — not necessarily because we like them, but because it seems appropriate to apply the standards that exist, as opposed to the ones we might wish existed,” Taub said in a June speech at the University of Southern California.

“Contrary to popular belief, I think the staff here is very good at dealing with a principles-based environment,” says Taub. “Just off the top of my head, I can count six times in the past two months when we accepted an issuer’s interpretation because they’d gone through a reasonable process to reach a reasonable interpretation, even though it wasn’t our preferred application of the standard.”

Escaping the Snarl

With so many factions at odds over so many issues, loosening the rules will require a substantial collective effort. Herz admits as much in calling for a “national initiative,” but is vague about what that would entail. Taub confirms that “a lot of people have been talking” about forming a working group that would look at ways to implement principles-based accounting. The hottest potato for any such group will clearly be how to protect every judgment from spawning an SEC enforcement case or a lawsuit without stripping the regulator of its authority or shareholders of their rights. (The last major effort of this sort, the Private Securities Litigation Reform Act of 1995, has so far done little to stem the tide of shareholder litigation.)

One thing is clear: principles are unlikely to prevent fraud any more effectively than a rules-based system does. “The fact of the matter is, if people want to falsify documents and fabricate transactions that never happened, they will do so under any accounting standards,” says Taub. But if principles won’t necessarily mean less-diligent law enforcement, they may create one enormous change: accounting standards that rely on logic rather than legalese. Groucho would approve.

Alix Nyberg Stuart is senior writer at CFO.

Fewer Rules, but More Disclosure

Notwithstanding the roadblocks, the Securities and Exchange Commission and the Financial Accounting Standards Board are set on moving toward principles-based standards and enforcement. What does it mean for finance chiefs?

First, CFOs will likely have to offer their finance staffs some education on the topic. Principles-based accounting “is something FASB talks about all the time, but around the company there are very few people who would be interested in a prolonged discussion on it,” says Lyondell Chemical controller Charles Hall. In the years ahead, accountants will also need new skill sets, predicts CVS Corp. CFO David Rickard. “In the long term, we have to make sure accountants are equipped to make judgments — maybe get them involved in strategy and give them a year or two to work on areas outside their technical training,” he says.

Second, companies can expect to be asked for even more disclosure. Even now, Scott Taub, the SEC’s deputy chief accountant, believes that some of the problems associated with too many rules could be solved through better explanations. “There’s nothing to prevent a company from adding more disclosure about financial instruments,” one of the most rule-laden areas, he notes, but companies generally stick to the minimum.

On the plus side, though, Taub says finance chiefs should also expect to have fewer restatements, since most current restatements “are just misapplications of accounting standards, not intentional deceit.” There’s also the promise of lower costs for financial reporting, because better-organized standards should require less technical expertise and make for shorter documents. — A.N.S.