Setting a new direction for U.S. standards-setting?

by Melissa Klein

The Securities and Exchange Commission’s endorsement of a principles-based approach has, in the eyes of some members of the profession, removed any lingering uncertainty about the direction in which U.S. accounting standards- setting is headed.

But observers say that getting there requires nothing short of a change in the thinking of all the players involved.

“Now that the SEC has said that they agree that the principles-based approach is the way to go, that pretty much answers any questions about which way we’re going to be going,” said Stephen McEachern, chairman of the American Institute of CPAs’ Technical Issues Committee.

The debate over principles-based standards versus rules-based standards has roiled the profession for years.

The issue has drawn increasing attention as convergence with international accounting standards has become a larger issue. Critics of detailed, rules-based standards say that they allow loopholes for those who want to engineer their way around the standards’ intent, as well as being difficult to use and costly to implement.

On the flip side, principles-based standards, which are based on broader concepts and require preparers and auditors to exercise significant judgment, are criticized for providing insufficient guidance to be applied consistently.

At least part of the problem lies in confusion over the definition of “principles-based.”

“When we talk about principles-based standards, nine out of 10 people will say yes, they favor principles-based standards,” said former SEC chief accountant Lynn Turner, who is now a managing director at financial consulting firm Kroll Zolfo Cooper. “Then when you say, ‘Okay, so you’re willing to give up LIFO or FIFO?’ a lot of hands come down, and people say, ‘That’s not what we meant.’ A lot of people don’t realize what we’re talking about.”

In its study on the adoption of a principles-based accounting system by the U. S. financial reporting system, which was required under last year’s

Sarbanes-Oxley Act, the SEC staff recommended developing accounting standards under a principles-based approach, which it labeled “objectives-oriented.”

In its report, the SEC said that such standards must be based on an improved and consistently applied conceptual framework; clearly state the accounting objective of the standard; provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis; minimize the use of exceptions from the standard; and avoid the use of percentage tests (“bright-lines”) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.

The Financial Accounting Standards Board, which sets accounting standards, issued a proposal for a principles-based approach to standard-setting in the fall.

“The board has been supportive of a principles-based approach. At the same time, the board realizes that you can’t simply have a principles-only approach to accounting standards-setting, neither can you have a rules-based accounting approach only to standards-setting. It needs to be a combination,” according to FASB spokeswoman Sheryl Thompson. “The views expressed in the SEC study are consistent with what FASB has been looking at and has talked about in previous meetings in 2003.”

“This is an important statement by the SEC. It’s the first time the SEC staff has really acknowledged and supported principles-based standards,” said former FASB chairman Edmund L. Jenkins, adding, “There’s a lot that has to take place if we’re going to have principles-based standards, which I think is worthy goal. It requires a change in approach and attitude by all participants.”

For starters, Jenkins said, “The SEC staff have to recognize that well-meaning, highly qualified people in both the corporate and audit communities come up with different answers in applying principles in the same circumstances. [The SEC staff] have to tolerate that. Part of the reason the rules we have are so complicated is because the SEC for too many years insisted on absolute conformity from one registrant to another. You can’t have that without detailed rules.”

“Companies that prepare financial statements have to stop asking their auditors, ‘Where does it say I can’t do this? Show me where I can’t do this, or I’m going to do it.’ And auditors have to not give in to that kind of pressure,” Jenkins added. “To some extent, I think it’s inevitable that we’ll move toward a principles-based system as we try to converge our standards and international standards,” he said. “It requires that we be broader in the approach we take to standard-setting.”

“It doesn’t matter whether you go with a rules-based or a principles-based approach,” added Turner. “Unless you’ve got a strong enforcement mechanism, you won’t achieve your desired result.”

“The same objective-based approach to rule-making that the SEC is saying FASB should follow will also need to be followed by the [FASB] Emerging Issues Task Force,” said Turner. “The EITF is probably the single greatest source of rule-based standards that fail to provide transparency or protect investors. Its guidance has become so voluminous that chief financial officers and controllers may not have a prayer of keeping current on all of its pronouncements.”

Turner added that standard-setters need to periodically reassess the standards to see if they are working as expected. “Too often, we have seen standards issued, such as those on leases, that have failed to achieve the desired objective. Yet, despite all the known problems with this standard ... the board has not redone it to fix the problems. Instead, they keep slapping a band aid on the patient until they look like a mummy.”

“The concept is a good one,” McEachern said of the approach outlined by the SEC. “The problem still exists that it’s going to be difficult for financial statement preparers to consistently adopt these principles-based accounting standards without some interpretive guidance, and I didn’t see that really addressed.”

“For practice to be consistent and for similar transactions to be booked and reflected similarly in financial statements, it will be necessary for the American Institute of CPAs, or some other body, to become more proactive in providing interpretive guidance,” said McEachern. “The small practitioner doesn’t have the resources a big firm has to do the research and determine how matters should be handled when it’s not spelled out in the standard.”

“It’s a thoughtful report. They answered the question that Sarbanes-Oxley threw at them,” said Robert Elliott, a past chairman of the AICPA and a retired partner of KPMG. But, Elliott said, “It’s a thoughtful answer to the wrong question.”

“The question isn’t how to tweak the old reporting model,” said Elliott. “It is how to facilitate the emergence of a new reporting model that is investor-driven, technology-enabled, and better suited to the post-industrial economy.”

“If you’re going to stick with the old model, it doesn’t need any major tweaking,” Elliott said. “It’s like saying you make buggy whips and you’re going to keep making buggy whips. You can use better quality leather, better stitching, better dyes, but what’s the point? Why not take the opportunity to move away from buggy whips and move into the next era?”

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