PwC U.S. Chairman calls for balance between rules and principles.

Dennis Nally, on behalf of his firm, PricewaterhouseCoopers, wants to get the issue of principles-based accounting versus rules-based "out front and into the dialogue" of today's preparers, standard-setters, regulators and users of financial statements. "We have become so driven by a desire to make rules around financial reporting as explicit as we can," says the U.S. Chairman and Senior Partner of PwC, [that] "it has created a degree of complexity in the marketplace that makes it increasingly difficult for anybody to understand all of the rules."

Nally says this focus on compliance with the rules has him continually worrying about whether or not we're seeing the big picture, and whether accounting is really following the substance of transactions as contrasted to just strict compliance. "Principles," he says, "are much broader than rules alone."

Nally says the accounting model in the U.S. and the profession over the past 10 to 15 years has encouraged a lot of rules to be promulgated "so that we could have absolute clarity on the accounting and financial reporting." We did it, he notes, for a host of reasons, like the litigation environment or the regulatory environment. The irony of the situation, however, is "I don't think having all of the rules has really addressed the fundamental problem: Is financial reporting and accounting really reflecting the economic substance of a transaction?"

He believes that we need to have the right framework and then encourage preparers of financial statements, regulators and auditors to use judgment--all of which is "absolutely critical for high-quality financial reporting and accounting."

He concedes the current framework contains potential inconsistencies with rules, which creates much confusion. For example, he cites lease accounting, lamenting that the U.S. has "probably one of the most complicated set of standards that govern lease accounting," the rules for which he describes as akin to an on/off switch.

The overall premise is to reflect the underlying economic substance of a leasing arrangement between a company and another organization. If you meet certain criteria around accounting purposes, it's either a capital lease or an operating lease. One of the tests is: if the present value of lease payments equals 90 percent or more, then it is a capital lease; if it's 89.5 percent, it's an operating lease. Then you step back and say: "That is a bright test. That is a rule. It's an on/off switch in terms of how you account for transactions." Yet, he says, you might be looking at the underlying substance of that transaction that concludes something very different.

The lease example, he says, is a case of how "you can have a rules-based decision drive the financial reporting for a transaction that in substance may be very different, if you look at the framework for what you wish to accomplish."

Nally believes there are a number of those types of instances, where the use of professional judgment--by the preparer, auditor or regulator--is being put on the back burner in relation to the specific rule that really governs accounting or financial reporting.

Historically, he says, the U.S. has been admired for its high-quality, meaningful and relevant financial statements that investors and others could rely on. Today, there is clearly a different point of view on this topic between U.S. and non-U.S. systems. A lot has been said about how different the two systems are, and part of the challenge for global capital markets, Nally says, is: "How do you begin to bring about convergence between a very rules-dominant U.S.-based system and an international system that's got more of a principles framework? And how do you get the two to move to the center?"

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Applying Principles

So, would a principles-based system have prevented an Enron, WorldCom or another big corporate scandal? Nally says, "There is no question that when you step back and look at specific rules that have this bright, on/off kind of switch, there are ways to engineer transactions to obtain a desirable result that is a by-product of a rule that's out there." That, he says, is a real challenge.

"You can comply with the rule, but have you really satisfied the economic substance of a given transaction? Whereas, if you have a principle that says: 'Here's the framework of how you think about a particular transaction,' and you need to be in compliance with that principle--which is based on the underlying economic substance of a transaction--then one would say, you could have achieved different results applying a rules-based versus a principles-based approach."

But, can't principles be interpreted differently by different people? A fair question, he says, since one underlying premise of a rules-based system is to ensure consistency from one preparer to another or one auditor assessment to another.

Now, he's not urging that we eliminate all the rules or all the guidance, but rather is suggesting moving in the direction of a principles-based framework, together with some rules--with a caveat: "You have to be in a position to accept that reasonable people will have different views around the application of a principle, that that is a necessary by-product of moving in that direction."

There is always the fine line, and where you are in the pendulum may affect the outcome. "In a principles-based system, if you have identical facts that have underneath a highly consistent set of economics driving a particular transaction, you would expect that different individuals looking at that fact pattern with those underlying circumstances are going to get a highly consistent response in terms of how you think about that transaction," he says.

The irony, however, is the likelihood of getting consistent fact patterns, particularly when dealing with complex transactions. That is why a rule is written, and why you try to achieve that kind of consistency, he says.

Thus, Nally argues that in order for the U.S. to move towards a principles-based framework, "there has to be an acceptance by all involved in the financial-reporting process that there will be differences, and that differences are okay; that informed, reasonable professionals can reach different conclusions based upon their assessment of the underlying facts and economics." Also, all involved will need to get more comfortable with differences from what has historically driven the financial reporting thought process and rule-making process within the U.S.

Changing U.S. Mindsets

Does Nally believe the U.S. is capable of making this mindset change? And couldn't the change spark increased--not decreased--litigation?

He concurs that such a shift requires a much different mindset than what has been demonstrated historically. "What's interesting is that all the reasons that were articulated in the past about why a rules-based approach was so critical--to drive consistency, deal with potential litigation, deal with second-guessing coming from auditors, regulators, etc.--all of those drivers for the rules-based system were out there for a long time. When I step back and look at where we are today, I question whether or not we are really accomplishing the end objective."

So, those issues are going to continue, he says, whether it's principles or rules. From a personal standpoint, Nally says, "I'd prefer defending my work based on professional judgment that reflects my assessment--or my firm's assessment--on the economic substance of transactions, versus, [saying] 'I was in compliance of Rule number X, paragraph Y. I understand the transaction may not meet the economic substance, but that is what the rule says to do.'"

Will Principles Ease Preparer, Auditor Relationships?

Clearly there has been much strain in preparer/auditor relationships, driven by the Sarbanes-Oxley Act, and particularly complying with Section 404 of the Act. As one who has been in the business for 32 years, Nally cites the amount of stress that was created over the last 18 months for preparers and auditors facing "incredible challenges--a complex new standard, for which everybody under-estimated the amount of time and resources that were necessary for compliance. And, of course, everybody was concerned about meeting the deadline."

Compounding the stress: guidance was being formulated throughout the process, strict deadlines were set, significant costs incurred--internal costs and, of course, the external costs, the audit itself.

In hindsight, Nally notes the tremendous undertaking by corporate America and the accounting profession for year-one. Year two, he says, seems to be going more smoothly, thanks to the guidance that came out last May from the Public Company Accounting Oversight Board (PCAOB) and the SEC around auditor use of judgment, which takes more of a risk-based approach in dealing with Section 404 issues--"exactly what was necessary to get clarity in terms of how to think about standards," he says.

But, Nally adds, what is really going to make all of the work a lot better, is that the role of the independent auditor providing advice to clients is seen as adding value to the process, and that auditors are working with clients, in a collaborative way, to enhance overall financial reporting. "That is what has made our profession so great in the past, and that will be critical for us to continue to add value to the financial-reporting process going forward." He's encouraged with the added clarity on what auditors can and can't do.

Nally strongly believes a principles-based approach will allow auditors "to continue to provide our point of view and express our judgment around essential accounting and financial reporting matters. Historically, that's what's made the profession such a valuable part of the financial reporting process. That is absolutely essential."

Finally, he underscores: "I'm not suggesting that we move all the way over to a principles-based approach. I think there are instances where you've got to have the right balance between the framework of the principle and the underlying specifics around rules. We've got to get that pendulum back to get the right balance between principles and rules.

"If we do that, and do it right, and in a collaborative way, it will make the financial reporting process much better. We [at PwC] are trying our best to get this dialogue moving, and hopefully, if we're all focused on that, I think we can move forward."