Perspectives

January 2004

The Future of Standards Setting

By Mike Ng

During the past decade companies have created increasingly complex transactions that often fall outside the scope of accounting standards. This has lead to an increase in corporate fraud, as evident by recent scandals such as Enron, WorldCom, Adelphia, and Global Crossing.

Additionally, energy companies, such as Dynegy, Reliant Resources, and CMS, have engaged in “swap” or “round trip” transactions, which involved one company selling power to the other and purchasing the same amount in return. The transactions did not result in the companies obtaining any economic benefits. Nevertheless, each company recognized revenue on the transaction, which boosted earnings and gave the perception that there was a high demand for these services. These events have led many critics to question whether a principles-based approach to standards setting might produce more transparent financial statements.

Rules Versus Principles

In general, the main difference between rules-based and principles-based standards is the level of detail. Principles-based standards provide general guidance or concepts, similar to FASB’s Statements of Financial Accounting Concepts (SFAC), while rules-based standards are more specific and provide specific guidelines, such as FASB’s Statements of Financial Accounting Standards (SFAS).

Adoption of principles-based standards. Due to recent accounting scandals, many critics have suggested the adoption of a principles-based approach. Proponents claim that standards issued under such an approach would be less complex, take less time to be issued, and cover a broader range of transactions. Use of principles-based standards would also ease the convergence of U.S. GAAP and International Accounting Standards (IAS). The main benefit of adopting a principles-based approach, however, would be to produce more transparent financial statements.

In recent years, there has been a proliferation of new accounting standards, which have become more detailed, technical, and obscure. For example, there have been 14 SFASs during the past four years. SFAS 133, Accounting for Derivative Instruments and Hedging Activities, is approximately 250 pages long, not including amendments by SFAS 137 and 138 and the Derivatives Implementation Guide. All of this implementation guidance was issued because the standard was too complex for most users to apply without assistance. This is despite the fact that the principle behind SFAS 133 was simple: Derivatives represent rights or obligations that should be reported in the financial statements using a fair value approach, with the exception of certain items qualifying as a hedge.

Another criticism of standards issued under a rules-based approach is that they take too long to be issued. Principles-based standards would be more efficient in addressing emerging issues since they would be less specific and less detailed. This would also result in simpler standards that would be easier to understand and implement. FASB has issued a proposal for the adoption of a principles-based approach which states that interpretive and implementation guidance would continue to be provided to assist accounting professionals under a principles-based approach.

There are discrepancies in the accounting treatment for certain transactions in different jurisdictions around the world. IASs are principles-based, and adoption of a similar approach in the United States might help bridge the gap between these standards and lead to one global set of standards. It is important to note, however, that there are other differences between IASs and U.S. standards, such as IASs’ use of a fair value approach. Simply adopting a principles-based approach in the United States is only one step toward global standards.

The most important reason for considering a principles-based approach is to present financial statements that are useful to investors, creditors, and anyone that makes decisions based on corporate financial statements. Enron’s financial statements may have followed current accounting standards; however, these financial statements were also misleading. The technical requirements of accounting standards have lead some auditors to follow a “check the box” mentality when determining whether a company has complied with GAAP. This has resulted in some auditors looking at accounting pronouncements narrowly and not considering the overall substance of the transaction. Since principles would provide less specific criteria, it would be more difficult for companies to follow the principle without reflecting the economic reality of the transaction.

It is also important to note that many opponents to a principles-based approach argue that it would lead to similar transactions being accounted for differently. The same is true, however, of a rules-based approach. Take, for example, accounting for leases under a rules-based approach: A lease would be capitalized if a lessee uses the asset for 75% of the asset’s useful life (among other criteria). Consider, however, a lessee that utilizes an asset for only 74% of the asset’s useful life. There is little difference between these two scenarios, yet the accounting treatment is very different: a capital lease is recorded on the balance sheet and an operating lease is not.

Additionally, judgment is required in determining the useful life. If a machine’s lease lasts for seven years, a company can assert that the machine should last for 10 years. Thus, the lease would be considered an operating lease. Another company, however, may believe the same asset will last for only nine years, meaning it would be recorded as a capital lease. Therefore, the same transaction may be accounted for differently among different companies, even if rules-based standards are followed.

There are many apparent benefits of adopting a principles-based approach to standards setting. The main benefit, however, may be to remove the focus from compliance with technical standards and shift it to fair presentation of the company as a whole. Although technical compliance is necessary, the overall presentation of financial results provides the most useful information for decision makers, and this focus is necessary for the accounting profession to evolve with the business environment.

Maintaining a rules-based approach. Although critics have valid arguments for the adoption of a principles-based approach, the current rules-based standards should not be disregarded without close examination. Guidelines already exist which require companies to present financial statements in a form that is not misleading regardless of whether the specifics of the rules are followed. Looking back at some of the recent corporate failures, this aspect of the rules has been ignored.

When one looks at the cause of the problem in cases such as WorldCom, it is clear that the problem was not with unsatisfactory standards but with a blatant disregard for the current standards. WorldCom improperly capitalized certain expenses, which resulted in lower operating expenses, increasing the company’s net income. This activity was clearly in violation of current accounting standards and appeared to be driven by management’s desire to boost earnings. In fact, a move toward a principles-based approach might make it easier for companies to break the rules, because principles-based standards would require increased interpretive judgment. Additionally, some professionals, particularly auditors, want specific rules that provide guidance as a means to protect themselves in litigation.

One of the main problems with Enron was the myriad complex transactions. These transactions enabled Enron to hide billions of dollars in debt in nonconsolidated subsidiaries. Critics argue that use of principles-based standards would not have allowed these transactions to have remained off of Enron’s balance sheet, as the economic substance was that Enron was liable for the debt. But the AICPA Code of Professional Conduct, Rule 203, states that if following an accounting standard results in the financial statements being misleading, proper accounting treatment is to account for a transaction in a way that does not make the financial statements misleading. This is confirmed by several cases, most notably U.S. v. Simon (1969). In this Second Circuit case, Judge Friendly found that literal compliance with GAAP did not preclude auditors from being held criminally liable for producing misleading financial statements. Thus, regardless of whether principles-based or rules-based standards are used, companies should always produce financial statements that show the economic reality of transactions.

In the early 1970s, as with today, accounting problems raised concern within the accounting profession. To settle the critics, FASB was created and began work on the Conceptual Framework project, which resulted in the issuance of a series of SFACs. These concepts provided the general accounting principles to be followed when preparing financial statements. It seems that the profession has come full circle. The profession, however, is unlikely to benefit from a project that would mirror the Conceptual Framework. The problem appears to be that accounting principles are often ignored by financial statement preparers and auditors.

Conceptually, adoption of principles-based standards appears to be beneficial. Upon closer analysis, however, it appears that the current rules-based standards are working as intended. There will always be those who break the rules, but disregarding those rules in favor of a new set of standards is not the solution. Many of the components of principles-based standards have been, and can continue to be, put in place through FASB’s Conceptual Framework and SFACs.

Survey Results

When asked if companies could interpret and apply current accounting standards—which are predominantly rules-based—and still record a transaction in a way that does not properly reflect the economic substance of the transaction, an astonishing 93% felt that it was possible. When asked, however, if accounting for financial transactions under more general accounting principles, rather than specific rules, would provide better results in forcing companies to show the economic reality of a transaction in a company’s financial statements, only 7% agreed, while 80% disagreed. Another 13% of respondents stated that principles-based standards may provide better results.

Respondents noted the following pros of adopting a principles-based approach:

• Rules do not cover every situation, and they eliminate the need to consider economic substance. New transactions or events not originally contemplated by principles-based standards could be analyzed within those principles without having to amend a or create a standard.
• Principles would require more accountability.
• Principles must be argued for and rules are argued against.
• A principles-based approach would add simplicity to the process. Principles-based standards would result in easier-to-understand accounting practices and policies.
• A principles-based approach would lead to more professionally based decisions.
• A principles-based approach would reduce the volume of GAAP that accountants would be required to keep up with.
• Companies would not be able to design transactions just to get around the rules. Principles-based standards would require the substance of the transaction to be presented.
• Principles-based standards may result in more transparent financial results.
• There are varying interpretations of the current rules.
• Sometimes rules-based standards result in noneconomic outcomes being reported in the financial statements.

Respondents noted the following cons of adopting a principles-based approach:

• Both principles- and rules-based accounting can result in misleading financial statements. In the recent scandals, financial statement preparers deliberately presented false information. If the intent is to produce false financial statements, the intent and interpretation of both rules and principles will be ignored.
• Rules-based standards increase comparability and consistency.
• Interpretation of a principles-based standard relies on good-faith efforts by all involved, which recent accounting failures demonstrate does not always happen.
• Without boundaries, it would be difficult for auditors to draw the line over which a company’s interpretation of the principles goes too far.
• Principles-based standards ignore the reality of economic and competitive pressures on preparers and auditors to present a company’s results in the best possible light.
• A rules-based system is needed because of the complexity of transactions.
• All that is needed to adopt a principles-based approach is to place the SFACs at the top authoritative level.
• It would be difficult to turn back to principles-based standards (the Accounting Principles Board issued several standards in the 1970s that were principles-based), since companies, auditors, and analysts have become accustomed to rules-based standards.
• When standards were more principles-based, application of those standards resulted in varying interpretations of financial results.
• Accountants and auditors would need even more in-depth knowledge to determine the economic substance of complex transactions.
• Competitive and economic pressures on both companies and their auditors might cause them to interpret the principles more broadly, because it would be more difficult to show they did not comply with standards.
• Replacing prior detailed rules with principles may imply that those rules did not reflect the economic substance of a transaction and thus no longer need to be considered, whereas the rules-based standards have worked to reflect the economic substance of a majority of transactions.
• Due to the complexity of the profession, structural changes to the accounting process may increase the risk of misinterpretation and errors.
• Additional disclosure would be necessary to properly describe transactions.

The Verdict

Some argue that misleading financial statements could not have been issued if current standards were sufficient. These same critics have suggested that a principles-based approach may force companies to record transactions in a way that reflects the economic reality of the transaction. As the term “fraud” suggests, however, the rules were not followed in these recent scandals. Additionally, FASB has issued a proposal for a principles-based approach and has recognized that participants must be willing and committed to making changes if a principles-based approach is going to work.

In order to ensure that financial statements reflect the economic reality of transactions, management and auditors need to focus on the big picture. If compliance with a standard does not reflect the economic substance of the transaction, the standard should not be followed. Previous court cases have set a precedent which suggests that reflection of accurate financial data will limit auditors from liability, whereas strict adherence to the standards will not. The evidence from survey results clearly does not support adoption of a principles-based approach. Standards-setting bodies, such as FASB, should continue to improve on the current rules-based standards.

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