PRINCIPLES-BASED ACCOUNTING: WISHING AND HOPING

It’s been a decade or so since the FASB started talking about principles-based accounting.  We are not sure what caused the impetus, but we think the first serious discussion occurred when the FASB issued a document for public comment on October 21, 2002.  It wasn’t particularly compelling then, and it hasn’t gotten any better with age.

Given that the SEC might soon issue a statement about registrants and whether they may employ IFRS, which supposedly are more principles-based, we think it good to review the debate, such as it has been.  Actually, it has been more of a monologue by the FASB and the SEC, because they refuse to listen seriously to the many dissenters.

So let’s review the initial FASB document and the questions that were asked by the board.

This “proposal for a principles-based approach to U.S. standard setting” sounded good at first blush until you thought about it.  The chief impediment then was that a principles-based approach requires people who have principles.  While some managers and some accountants fit the category, others do not.  Just witness the cracks and crevices in financial reporting during the last decade!

FASB stated that “many have expressed concerns about the quality and transparency of U.S. financial accounting and reporting.  A principal concern is that accounting standards, while based on the conceptual framework, have become increasingly detailed and complex.”  While true, people must remember that accounting rules attempt to map the activities of the corporation into financial statements.  As corporate transactions grow in complexity, one should not be surprised that the FASB created accounting rules that also grew in difficulty and intricacy.  After all, it is a bureaucracy!

But it doesn’t have to be that way!  If you want to simplify the accounting for derivatives, then just fair value all of them and put the gains and losses in the income statement.  That’s pure and simple.  If you want to simplify the accounting for special purpose entities, require all of them to be consolidated.  There is nothing requiring the rules to be complex. See our discussion in Accountants Behaving Badly.

In the 2002 document, the FASB quoted SEC Chairman Harvey Pitt: “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.”  Besides quoting somebody who didn’t understand Enron, FASB quoted a statement that is as silly as it is disingenuous.  Managers are not going to quit engineering financial results with the creation of principles-based accounting; indeed principles-based accounting will enhance such financial engineering because it helps managers to disguise the truth about their accounts.

The FASB stated that one reason for the current complexity of accounting rules is the development of exceptions to the principles.  While that seems accurate, let’s ask ourselves what would happen under a principles-based approach.  Corporate managers would apply the accounting principles to their situations, bending and twisting the principles to conform to their circumstances.

Exceptions to the principles would become applications of the principles themselves, as managers find ways to fit what they want to do with the accounting rules.  As exceptions become the principles, accounting in practice could in fact become far more complex for investors and creditors.  The investment community would have great difficulty in comprehending how corporate managers actually implemented the accounting rules. Er, principles.  Worse, it might make financial statements of companies less comparable with those in the same industry.  Indeed, a recent report by the SEC seems to imply this has actually occurred in those companies which employ IFRS (“An Analysis of IFRS in Practice”).

In the 2002 document, the FASB said that a second reason for the current complexity is that they must provide interpretive and implementation guidance.  In our litigious society, do we really think managers and auditors would quit asking for such advice under a principle-based system?  Not for a second do we entertain that idea.

The FASB also quoted the chairman of the International Accounting Standards Board David Tweedie, “[A principles-based approach requires] a strong commitment from auditors to resist client pressures.”  We agree but wonder whether such an approach makes it easier or harder for auditors to resist those kinds of pressures.  Tweedie never addressed that issue.

As a final point, when we observe those European entities that follow IFRS, we ask whether the so-called principles-based approach has provided better valuations, more and better disclosures, and more candid discussions and analyses by management.  We think not.  The valuation issues plaguing the current European debt crisis provide support our opinion.

The conclusion appeared obvious ten years ago.  Those intent on pursuing the principles-based approach actually long for less reform and more accounting shenanigans.  We think nothing has happened in the last decade that amends our initial conclusion.

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.