Principles-based or rules-based standards?

The pendulum in the U.S. appears to be swinging towards sweeping change in accounting standards--from rules-based to principles-based. Besides support from CEOs on down at the Big Four, support is being voiced from the Financial Accounting Standards Board (FASB) as it moves towards convergence with the International Accounting Standards Board (IASB). Principles-based standards are used by most countries in the world--except the U.S.

In a survey conducted in August by Grant Thornton of its mid-sized clients, fully 80 percent said, "Yes," when asked, "Should we adopt a principles-based approach to accounting standards?" Of the respondent "yeses," 69 percent were from public companies, and 85 percent from private companies. Change doesn't come easily, and when it does, it generally takes time, and lots of dialogue.

So, as the earnest debates begin, Baruch College in New York City brought together a distinguished panel in late September to present their views on "Accountable Accounting: Principles or Rules." Moderated by Harvard University Law Professor Arthur Miller, the forum included stakeholders from corporate America, accounting firms, regulators, lawyers, academia and more. Opening arguments, er, statements were presented in support of either side, and those on the panel then presented their views. Among the panelists were: Colleen Sayther Cunningham, FEI's CEO and president; Philip D. Ameem, vice president & comptroller, General Electric Co.; Charles Elson, director, Weinberg Center for Corporate Governance at the University of Deleware; Katherine Schipper, board member, FASB; and Melvyn I. Weiss, senior partner, Milberg Weiss Bershad & Schulman LLP.

Arguing for maintaining the status quo with rules-based standards was William Bratton, professor of Law at Georgetown University Law Center, and on the side of principles-based standards was Grant Thornton's Managing Partner-in-charge of Accounting Principles Group, Joseph Graziano.

Bratton argued that as a corporate law academic who also teaches accounting, he has a "very specific point of view." Early in his career, he favored principles over rules--but said he later learned a second lesson: "The choice of the form of regulation, rules or principles, is not the critical factor in the process leading to the regulatory result of compliance or noncompliance. That depends more on the enforcement environment, which, in a self-regulatory system, depends on the incentives of regulated actors and professional gatekeepers."

[ILLUSTRATION OMITTED]

In the legal world, he says, these incentives changed between his law-school years and the bull market of the 1990s, as did lawyer-client engagements. Clients started to make "show me where it says I can can't do this" demands, and with the explicit prohibition, became more willing to do it even though the action "traversed the broader principles motivating the regulation," he said. There followed a downhill regulatory spiral, with counsel, now shy of applying principles to fact and making difficult judgment calls, now demand specific regulations. Legislative drafters supply them, and "worse, when lawyers assess the state of the law for their clients, the application of principles starts to yield to analytical and linguistic manipulation. At the bottom of the spiral, everybody just games the system, and you get Enron."

Bratton says the world of lawyers is no different from that of accountants. "I've been arguing for rules, due to a sense that principles-based regulation works well only in incentive-compatible institutional frameworks--contexts where nobody thinks that gaming the system is a good idea and clients respect the law to fact judgments of professionals." He says it's the Public Company Accounting Oversight Board's (PCAOB) core job to push the auditing context in this direction, but that process is at an early stage--too early to create a context fit for principles.

Bratton provided six "footnotes" detailing his position. Among them:

1. There's no such thing as a pure rules- or principles-based regulatory system. All are mixed and context-sensitive. All ultimately derive from principles. All ultimately produce rules when principles are applied to facts on repeated occasions.

2. Rules-based GAAP did not cause recent financial reporting breakdowns. If you look at the GAO's (General Accounting Office) catalog of restatements, it is true that many involved rules-based regimes, but more involved principles-based GAAP. This suggests we should look for deeper causes.

Bratton concluded: "In an ideal world, we should by all means have principles. But in the world we occupy, financial reporting needs all the rules it can get."

Arguing for a principles-based approach, Grant Thornton's Joseph Graziano provided a description of rules-based: "A standard that may be based on an underlying principle, but includes numerous bright-line tests, contains numerous exceptions to the principle underlying the standard and requires a significant amount of implementation guidance. At the extreme, think of trying to read and understand financial statements that are prepared using the Internal Revenue Code."

He cited a study of the approach to standard-setting conducted by the SEC staff in which they describe the characteristics of a principles-based or objectives-oriented basis to setting accounting standards.

Graziano cited FASB Statement 13, Accounting for Leases, as an example of a standard that is rules-based. Lease accounting, he said, is the subject of about 16 FASB Statements and Interpretations, 9 Technical Bulletins and 30 EITF Issues. Statement 133, Accounting for Derivative Instruments and Hedging Activities, is also a rules-based standard, and the latest FASB publication on derivatives runs more than 800 pages.

Graziano mentioned several benefits of a principles-based approach (some of which were included in the SEC study). A few of these benefits follow here:

1. Financial statements that are prepared using accounting standards that clearly state the accounting objectives, have few, if any, exceptions, and do not include bright-line tests should benefit users. They should be easier to understand, more meaningful and informative, are likely to result in similar transactions and events being accounted for similarly, and more likely to reflect the economic substance of a transaction, in part, because there will be less opportunity for financial engineering.

2. As an auditor, Graziano says he sees other benefits. For one, he believes auditors will spend less time and effort trying to understand and apply a detailed standard. He also believes it will be easier to discuss how to apply a principles-based accounting standard to clients in Grant Thornton's practice because most are middle-market companies that do not have the accounting resources to learn all of the nuances of a detailed rule.

[ILLUSTRATION OMITTED]

3. International convergence might be facilitated because standard-setters may be able to come to an agreement on a principle faster than a detailed rule.

Not mentioned in his remarks, but on his list, he noted the small-business community could benefit. Since it has been concerned about standards overload, a principles-based approach would focus on the accounting objective and include few, if any, exceptions.

Finally, Graziano asked: "Will moving to a principles-based approach to standard-setting be easy?" His answer: "No, it will take time and the commitment of the financial community."