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A key concern arising from the recent business scandals is that U.S. accounting standards
have become rules-based, filled with specific details in an attempt to address as many
potential contingencies as possible. This has made standards longer and more complex,
and has led to arbitrary criteria for accounting treatments that allow companies to
structure transactions to circumvent unfavorable reporting. In addition, the quest for
bright-line accounting rules has shifted the goal of professional judgment from
consideration of the best accounting treatment to concern for parsing the letter of the rule.
To address these concerns, the Sarbanes-Oxley Act of 2002 required the SEC to examine
the feasibility of a principles-based accounting system. The SEC rendered an interesting
study that focuses on objective-oriented standards (www.sec.gov/news/studies.shtml).
Accounting firm leaders have supported a move toward principles-based standards. Sam
DiPiazza, CEO of PricewaterhouseCoopers, and Ed Nusbaum, CEO of Grant Thornton,
have both publicly proposed a switch to principles-based standards. The Financial
Accounting Standards Committee (FASC) of the American Accounting Association
believes that a principles-based approach is more likely to result in transactions that
reflect their true economic substance. Finally, FASB Chair Robert Herz has said that the
current rules-based system is problematic because those who want to comply with
rules ... are not always sure of everything they need to look at. Those looking to get
around the rule can use legalistic approaches to try and do it (Business Week online,
2002).
Under a principles-based approach, one starts with laying out the key objectives of good
reporting in the subject area and then provides guidance explaining the objective and
relating it to some common examples. While rules are sometimes unavoidable, the intent
is not to try to provide specific guidance or rules for every possible situation. Rather, if in
doubt, the reader is directed back to the principles.
FASB member Katherine Schipper has explained that one of the overriding financial
accounting concepts is the usefulness of accounting information to decision makers. This
implies that the information should be relevant, reliable, and comparable across reporting
periods and entities. If the only requirements were that information be relevant and
reliable, entities would adopt reporting methods to best reflect the economic realities for
their particular entity. But this would make comparison between companies and across
reporting periods virtually impossible for investors.
The problem arises when standards setters approach the difficult task of determining the
appropriate level of detailed guidance to achieve sufficient comparability and consistency
in financial statements. A principles-based standard often becomes a rules-based standard
in an effort to increase comparability and consistency. An example of this process is
demonstrated by SFAS 133, Accounting for Derivative and Hedging Activities, which
requires that all financial instruments be measured at fair value. A fundamental question
addressed in this standard is the definition of a derivative. SFAS 133 provides three
paragraphs to define a derivative. FASB received so many questions about the definition
that the Derivatives Implementation Group has issued at least 22 statements to provide
additional clarification. A further question is how to measure the fair value of an
identified derivative. If no guidance is provided on this issue, numerous measures of fair
value are potentially justifiable: the asking price, the bid price, or the average of the bid
and ask prices. Thus, a rule was added to delineate exactly how fair value should be
determined. Thus, a principle requiring financial instruments to be measured at fair value
became a detailed rule with complex stipulations and exceptions that allow corporations
to structure contracts to achieve favorable reporting.
SFAS 13, the primary standard for lease accounting in U.S. GAAP, is an example of a
rules-based standard. SFAS 13 was enacted in an attempt to force corporations to
recognize the substance over the form of a leasing agreement. Specifically, during the
1980s, many companies began using leasing arrangements as a means of offbalance-
sheet financing. In some instances, companies would buy a piece of equipment, sell it to
another entity, and then lease it back to avoid recording an asset and a liability for the
equipment. SFAS 13 requires that firms distinguish between operating and capital leases
using four specific criteria, whose purpose is to ensure that leases that are essentially
purchases be treated as such (see the Exhibit). If a contract satisfies any of the four
criteria, it must be recognized as a capital lease in the financial statements. FASB hoped
that by providing explicit rules, individual judgment would be eliminated and the
standards would be consistently applied. In many respects, this strategy backfired.
Because precise rules were established, companies carefully structured lease contracts to
qualify as operating leases. As a result, the explicit rule allows the offbalance-sheet
financing to continue, and provides justification for the treatment.
What are the advantages and disadvantages of principles-based accounting? Perhaps the
primary benefit of principles-based accounting rests in its broad guidelines that can be
applied to numerous situations. Broad principles avoid the pitfalls associated with precise
requirements that allow contracts to be written specifically to manipulate their intent. A
1981 study sponsored by FASB found evidence that managers purposefully try to
structure leases as operating leases to avoid incurring additional liabilities. Providing
broad guidelines may improve the representational faithfulness of financial statements.
First, the current conceptual framework, which provides guidance for standards, has been
characterized by FASB as incomplete, internally inconsistent, and ambiguous. For
example, while FASBs Concept Statement 2 discusses the qualities of relevance and
reliability, it does not provide any guidance for trading one for the other. In addition, the
revenue recognition principles contained in Concept Statement 5 are frequently
inconsistent with the definitions of assets and liabilities in Concept Statement 6 (FASB
2002). Because of the current shortcomings of the conceptual framework, the first step in
establishing a principles-based system is to improve the accounting concepts and develop
an overall reporting framework.
Second, the number of exceptions contained in the standards must be reduced. Much of
the current detail in standards arises from three kinds of exceptions: scope, transition, and
application. Scope exceptions allow the use of prior standards to continue when a new
standard is adopted. Transition exceptions reduce the effects of changing to a new
standard. Application exceptions are granted to obtain a desired accounting result. For
example, to reduce the volatility of pension expenses, estimated returns on plan assets are
utilized instead of actual returns. While scope and transition exceptions would still occur,
FASB has proposed eliminating application exceptions in a principles-based system. The
reduction in exceptions would greatly reduce the details and complexity of standards and
more clearly reflect the economic events of an entity.
In a 2002 interview with Business Week, Herz indicated that a change to principles-based
standards would be gradual. Instead of starting all over, any new standards would follow
the principles-based method but existing standards would not currently be replaced.
FASBs goal would be a smooth transition rather than an abrupt switch in accounting
standards.
Rebecca Toppe Shortridge, PhD, CPA, and Mark Myring, PhD, are both assistant
professors in the department of accounting at the Miller College of Business, Ball State
University, Muncie, Ind.