Rules vs. principles.

They may be called generally accepted accounting principles, but you'd be hard-pressed to find a CPA who doesn't consider the U.S. system rules-based. Those rules, which are based on principles, have come under attack since the Enron collapse, and many are calling for a return to a straight principles-based system, similar to what the international Accounting Standards Board is adopting.

California CPA asked two CPA auditors, who closely follow the standards-setting process approach to accounting standards setting.

Stuart H. Harden and Andrew M. Mintzer, to debate the rules vs. principles-based

Stick With the Rules

BY ANDREW M. MINTZER, CPA

YOU CAN'T COMPARE APPLES AND ORANGES. However that is exactly what would happen in a principles-based system if you compared one company's financial statements to those of another company or a group of companies in an industry. Under principles-based standards, each company could determine its own unique way to apply GAAP, and you would have no assurance of consistency. You wouldn't know if the operating results were comparable, because they may have been arrived at using different accounting methods.

Most people probably would agree that a principle of financial statements is that they report the company's assets and obligations. But what if the asset is not owned by the company and is leased instead? Is there really any difference between a company that owns a fleet of delivery trucks versus a company that leases its fleet? Maybe, maybe not. Both companies enjoy the use of the trucks and both have obligations to pay for those trucks.

FAS 13--A PRIME EXAMPLE

Statement of Financial Accounting Standards No. 13 (FAS 13) is a prime example of a rules-based accounting standard that is based on a general principle. The general principle in FAS 13 is that assets and liabilities create benefits and risks, and those benefits (assets) and risks (liabilities or obligations) ought to be reported in financial statements.

If preparers decided individually what benefits and risks constituted assets and liabilities, there undoubtedly would be variation. Some preparers might classify a lease as a capital lease if the lease payments were more than half of the total value of the property, and some might use a percentage closer to 100 percent. When FASB developed a "rule" to guide this principle, it chose 90 percent.

Rules-based accounting standards can be high maintenance, since users crave answers for their specific situations.

Since FAS 13's issuance in 1976, many of its 51 paragraphs have been amended, superceded or interpreted by more than 40 different FASB statements, interpretations, technical bulletins and EITF issues at least once, if not more.

DEBATE AND DELIBERATION ARE KEY

Sure, that's a lot of rules, but they are developed and deliberated by accounting experts without the influence of a particular business financial statements in mind. It is this due process and public debate in developing accounting rules that result in our high-quality standards.

Principles-based standards simply would move the debate and deliberation away from the public forum and into each accounting department where the results would be inconsistent and perhaps unknown.

There is an increasing amount of complexity in rule-based accounting pronouncements. Most standards aren't complex in the sense that they are intellectually difficult or too complicated to figure out. Rather, they are complex in terms of the number of variables and possible outcomes in their application.

FAS 13 has four separate tests to determine if a lease is a capital lease, based on the varied factors of lease term, relative amount of lease payments, bargain purchase option and title transfer.

But what if the "rule" was changed to simply require capital lease treatment for all leases with terms of one-year or more? This would still be a rules-based standard that would result in a consistent application among financial statement preparers.

Are we trading complexity for inaccuracy? Many would argue yes, because, in reality, not all one-year-plus lease are capital leases.

MAKING RULES-BASED WORK

Effective rules-based standards require active participation of the financial reporting community to evaluate the resulting quality. Real life practice issues should be brought to the attention of the appropriate standards-setting bodies so that they can be incorporated into the standards in a timely and meaningful fashion.

Finally there should be a reasonable relationship between the number of possible outcomes of a rule (its complexity) and the quality of the resulting accounting measurement or disclosure. This way, rules-based standards will provide both the consistency that financial statement users crave and the high-quality financial statements they demand.

Andrew M. Mintzer, CPA, is a sole practitioner based in Santa Monica. He can be reached at [e-mail].

Time to Move to Principles-Based Standards

BY STUART H. HARDEN, CPA, CFE 

TALK ABOUT COMPLEX. Have you read Statement of Financial Accounting Standards No. 133, Accounting For Financial Instruments? It's extremely complex. Much of it is understandable to only a few individuals who have worked regularly with these issues. FAS 133 spans 153 pages, and is supplemented by numerous EITF issues and FASB staff interpretations. In fact, FASB formed a special group, the Derivatives Implementation Group, just to deal with the numerous implementation issues.

You might say that FAS 133's complexity is a result of complex financial instruments, and that one only needs to become familiar with this issue if they are involved in large entities that are parties to such instruments. Well, not necessarily. In fact, virtually all entities hold financial instruments as defined by the FASB, and we all need to understand the provisions of this statement.

CLEARER AS A PRINCIPLE

FAS 133 could be fairly brief and uncomplicated--perhaps only two paragraphs long--one paragraph describing what a financial instrument is, and the other indicating that they should be valued at fair value.

Too simple? Perhaps, perhaps not.

Accounting standards could be written in a principles-based manner, but at a cost. In my view, what we give up may be less important than what we gain.

What would we gain?

Principles-based standards would provide the basic principle of accounting such as, "All financial instruments should be valued at fair value." These would be brief, easier to understand, provide latitude to financial statement preparers in applying the principles and easier to conform with international standards, which are less proscriptive and require less modification over time.

For example, currently, as the business community develops new financial instruments, which circumvent the rules, our rules-based accounting standards must be tweeked to avoid undesirable results. As the volume of standards grows, the complexity does as well, and we are left with our heads in our hands.

A SMALL PRICE TO PAY

What would we give up?

In short, conformity. Different financial statement preparers may develop different methods of determining fair value, resulting in similar financial instruments being valued differently.

What else?

Exceptions. Principles-based standards would have no exceptions. Clearly, the complexity of accounting standards has developed, in part, because of exceptions. For example; principles-based standards may require that there be no exceptions to fair value rules for financial instruments, even if used in hedging transactions; all leases over one year might be capitalized; and all stock options might be valued at market.

In measuring the benefits against the costs, consider this: Despite our efforts to achieve conformity, diversity still exists. Our efforts to allow exceptions have added confusion to the marketplace. What we hoped to achieve by writing accounting standards in a detailed and proscriptive manner has eluded us.

NO TIME LIKE THE PRESENT

Now is a perfect time to consider a change to principles-based standards. The crisis in financial reporting has resulted from misuse of current standards and mistrust of corporate management and auditors.

Principles-based standards would place responsibility for reporting the substance of transactions squarely on management. Management would no longer be able to say to their auditors, "Show me where it says I can't do it this way." Instead, management would be required to convince the auditors that their accounting methods comply with the basic accounting principles.

Management and auditors would be required to step back, look at the overall results of the accounting methods selected and agree that such methods are in line with the basic principles.

In addition, the current standards are difficult to apply internationally, making a uniform set of worldwide standards impossible to achieve. Investors generally agree that one worldwide set of standards would enable capital to move more freely, benefiting all.

Now is the time to make the hard choices, weigh the pros and cons, and move in the direction of principles-based standards.

Stuart H. Harden, CPA, CFE, is a director in Hemming Morse's San Francisco office. He can be reached at [e-mail]