In our prior column, we began to explain the importance of having Rule 203 exceptions, both as a matter of quality control and as a portal to progress for managers who realize that generally accepted accounting principles aren't good enough.We also strongly criticized the Financial Accounting Standards Board for proposing to eliminate 203 exceptions in its recent exposure draft on the GAAP hierarchy, on the basis that if a rule is generally accepted, it automatically must produce relevant and reliable information. Frankly, we don't think that the board could be more wrong, both in eliminating 203 exceptions and in their claim that GAAP is not merely good, but dang near perfect.
In contrast, we see Rule 203 exceptions as extremely important safety valves for avoiding situations in which financial reporting emphasizes form over substance. Certainly, the pursuit of useful reporting must trump blind compliance with politically derived rules.
A couple of years ago, we wrote about 203 exceptions and how they could have prevented some of the damage done by Enron's collapse. We're reprinting it because its points are central to understanding why FASB is sorely mistaken in proposing to get rid of the exceptions. In the next several columns, we'll explain more about why GAAP is not a gold standard of usefulness. Indeed, it is so bad that we think 203 exceptions should abound, instead of being as rare as hen's teeth. Read on to find out why.
Tucked away near the heart of the American Institute of CPAs' Code of Professional Conduct is Rule 203, entitled "Accounting principles." It consists of no more than two sentences, albeit long ones. What seems to happen in practice is that only the first one is observed. The second one is just as important, but is totally ignored; if it were not so, we think that some of the Enron debacle could have been avoided.
The first sentence forbids AICPA members (or CPAs governed by similar rules in their licensing states) against opining or otherwise stating affirmatively that financial statements are presented in accordance with GAAP if they do not comply with standards issued by bodies designated by the institute's Council as authoritative. In effect, this rule gives standing to rules issued by FASB and others, and is obviously crucial for credible financial reporting.
But we're writing about the second sentence, which says, with some convolution, "If, however, the statements or data contain such a departure [from GAAP] and the member can demonstrate that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement." That mouthful basically says that CPAs are obliged to depart from GAAP if complying with those principles will produce information that is misleading.
This sentence testifies to the fact that some past leaders thought deeply enough about accounting to understand the risks of blind compliance with politically derived accounting principles. Knowing that unenlightened managers will try to manipulate security prices by managing reported earnings within GAAP, these leaders put the onus back on auditors and other CPAs to ensure that they would not approve such machinations simply because they are "acceptable."
We venture to say that this idea is virtually unknown to today's practitioners. Instead, it appears that they want to deal only with the black-and-white questions of whether management's policies are specifically allowed by GAAP, or, alternatively, not disallowed by GAAP. As tough as this task might be, it is much easier to perform than the one that Rule 203 defines as essential.
Specifically, the second half of the rule calls on accountants to judge not just whether compliance has occurred, but whether the information produced by that compliance is actually useful to those who receive and analyze the statements. That duty is much more complex because it demands three things of accountants.
First, it compels them to fully understand the truth. That's hard, because they have to spend time and effort figuring out what happened and what exists in the real economic world. It does not embrace thinking that permits CPAs to complacently accept either FIFO or LIFO according to management's wishes.
It also should have led auditors and accountants to decide that pooling-of-interest accounting for combinations was misleading and therefore unsuitable for use, even though it was permitted.
Second, applying all of Rule 203 requires CPAs to develop new methods of accounting that are more useful than the ones identified by the political standard-setting process. It also requires auditors to assess the usefulness of the new information in terms of its ability to describe the truth. This kind of activity is light years beyond merely running mechanical tests to see whether a lease is operating or capital, or whether all 12 pooling criteria were met. The real test is the truthfulness of the information, not the structure of the transactions or the flexibility of GAAP.
Third, implementing the second part of Rule 203 is challenging because it means that accounting employees and auditors have to stand up to managers and tell them that they won't go along with practices that cleverly rig the reported GAAP results. While taking a stand might cost them their jobs or their client, it's also true that not standing firm costs them their integrity and self-respect. We also think not standing up for the truth causes the capital markets to look with contempt at the information in all companies' financial statements and discount their security prices because of the resulting uncertainty.
Someone might notice that Rule 203 has permissive language, because it uses the word "can" instead of "must." Only a hair-splitter would conclude that this choice of words actually relieves CPAs of their professional obligation to honor the truth and thereby serve both their clients and the public.
We find great instruction in reading the discussion of "Integrity" in the AICPA's Code. We note these thoughts in particular: "Integrity is measured in terms of what is right and just. In the absence of specific rules, standards or guidance, or in the face of conflicting opinions, a member should test decisions and deeds by asking: 'Am I doing what a person of integrity would do? Have I retained my integrity?' Integrity requires a member to observe both the form and the spirit of technical and ethical standards; circumvention of those standards constitutes subordination of judgment." (This second sentence is one of the origins of the title of our column.)
Thus, the Code makes the test of acceptability the question of whether the truth is delivered with integrity in the financial statements. It means that mere compliance with the technical provisions of GAAP isn't enough. Thus, CPAs must challenge their superiors or clients to accomplish "what is right and just."
What does all this have to do with Enron?
We again look at the words attributed to Joe Berardino in the Dec. 4, 2001, issue of The Wall Street Journal in the op-ed column entitled "Enron: A Wake-Up Call." Near the middle of this public plea for leniency for his firm, Arthur Andersen, Berardino accused Enron's management of taking advantage of provisions in GAAP that did not forbid using special-purpose entities to achieve off-balance-sheet financing. With a figurative shrug of his shoulders, Berardino laid the blame for this behavior on the authors of GAAP and thereby expected Andersen to be absolved of any blame, even though the auditors knew full well that compliance created misleading statements.
To a strict technician with no sense of the truth, much less a commitment to pursuing it, Andersen might be blameless. However, that verdict won't be reached by authentic professionals, who understand that deliberate deception is neither right nor just.
In this case, Andersen's complacency seems to have violated Rule 203, while causing many people to lose their savings and their jobs, not to mention raising the cost of capital for other companies through diminished confidence in all audited financial statements.
The truth can be known, and judgments can be reached about its reflection in financial reports. There is no excuse for ignoring the second half of Rule 203. The world would be a better place if CPAs embraced the whole Code, instead of just the convenient parts.
And the world will be worse off if FASB singlehandedly deletes 203 exceptions. Our next columns will show the fallacy in the board's premise that GAAP produces relevant and reliable information. It just ain't so.
Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at
