The Spirit of Accounting: The Answer Is in Truth-Telling, Not Detailed or Broad Standards

We are republishing some classic Spirit of Accounting columns while we're extra-busy with a new major project. We selected this one because (alas!) several of its points are just as valid today as they were when it was printed in October 2002 following the spectacular string of accounting and management frauds that brought down one large public company after another and put Big Five firm Andersen in the past tense. Several themes should reverberate with today's readers more than a decade later.

First, we still see managers blaming accountants for enabling their lying behavior. (No, we still don't understand that point, either.)

Second, back then there was a ferment to fix things by giving managers more latitude to concoct even more elaborate fairy tales in the financial statements. Sir David Tweedie, the chair of the International Accounting Standards Board at the time, made the excellent rebuttal point that principles-based standards require managers who don't lie and auditors who stand firm; unfortunately, he seemed to have forgotten this key concept a few years later when he kept urging the Securities and Exchange Commission to embrace the IASB in place of the Financial Accounting Standards Board on the basis that IFRS are not detailed rules.

Third, liars will lie in financial statements regardless of what sort of standards are in effect. Therefore, the only good solution is a whole new paradigm that truth-telling is far and away the best and perhaps the only financial reporting strategy that will achieve what every manager should want: lower capital costs and higher stock prices. Fourth, there wasn't much hope for that to happen under the management of the generation that wreaked so much havoc. We actually don't have much hope for those who filled their shoes, either, because they swallowed the same nonsensical whopper that they can manage capital markets by manipulating their financial reports. Read on.


If the subject wasn't so serious, we would be laughing at two things we have read that both argued that the recent business catastrophes were caused by FASB's insistence on writing detailed rules, instead of establishing broad standards. Two former chief executives, Walter Wriston of Citicorp and Joe Berardino of Andersen, are on public record claiming that broad principles would be far more useful than pages and pages of nitpicky accounting regulations.

Of course, one of the tricks of propaganda is to present a story that appeals to readers because it matches what they want to believe is true, never mind the facts and never mind who is speaking or writing. Perhaps that's what is happening here.


Principles, or a license to lie?

The Aug. 5, 2002, Wall Street Journal presents Wriston's assertion that things would have been different if GAAP consisted of only a few principles-based standards. His bold statement lacks a firm foundation because, in fact, executives have always wanted the free rein of broad standards because of the leeway they create. What they would prefer more than anything would be guidance like, "Report income when it has been earned," "Put all liabilities on the balance sheet except those that don't belong there," and "Report whatever you want for employee compensation; after all, it's your company and your money."

To state our point unfacetiously: The whole reason for having GAAP has been to constrain the tendency of CEOs to manipulate their statements. Thus, a call from that sector for reform falls on totally deaf ears when it arrives at our offices. If, on the other hand, it had been offered by someone from the user community or even the CEO of AMB Properties (who advocates reporting options expense on the income statement), we would be more inclined to listen.


Berardino on tempation

Of course, Berardino's name will be forever linked to the demise of the once-respected, even revered, Andersen, because his hand was on the helm when the Big Five morphed into the Final Four. He is on record as testifying before Congress that his firm had no choice but to issue a clean opinion because Enron's financial machinations complied with GAAP. He also was the final stopping place for the buck that removed Andersen's Houston partner, Carl Bass, from the Enron audit team because the client didn't like it when he kept raising so many objections.

In a cover story titled "Fall from Grace," the Aug. 12, 2002, Business Week documents the rise and fall of Berardino's career. Included in the article is an ironic sidebar with this advice for the next generation (as if he would be a good source of sage counsel): "Change the financial reporting system so it is based less on 'a game of rules, loopholes, and legalisms' and more on principle-driven accounting ..." To which we say: Hogwash.

While there may be good reasons for broad standards, we know they won't deter people who believe crime pays. The bad guys will be bad no matter whether the rules are narrow or broad. As we see it, opportunities for accounting sleight-of-hand tricks are greater if only a few broad standards are in place.


A whole new paradigm is needed

Undeterred by his wobbly pulpit, Wriston says that depending on detailed rules "engenders a mindset among accountants, auditors and managers to ask the wrong question: 'Is it legal?' instead of 'Is it right?'"

While he's correct that detailed rules may promote legalistic thinking, it doesn't follow that broad rules would automatically produce high-minded decisions to implement useful accounting policies.

In our view, what is needed is a totally fresh mindset that believes financial reporting involves openly declaring and explaining what actually happened, instead of playing the pointless, even hopeless, game of filtering, coloring and retouching.

Would broad standards deter some of today's executives from using creative GAAP to squeeze a few extra pennies into EPS to escape the fate of falling short of a quarterly target? Not unless they totally abandon their current predilection to consider false but pretty pictures more useful than accurate depictions of reality.

Without these overhauled minds, giving managers broad standards would surely turn them into kids in a candy store and virtually destroy the credibility (and the usefulness) of financial reports. As support, both Wriston and Berardino suggest that the IASB has it right by relying on broader standards. Ironically, Wriston quotes David Tweedie, the IASB chair, as saying that, "This approach requires a strong commitment from preparers to provide a faithful representation of all transactions and a strong commitment from auditors to resist client pressure." Tweedie is right, and is thus miles ahead of Wriston.


Usefulness demands the truth

Despite clear evidence of the pointlessness of false reports, there is still no strong commitment among U.S. CEOs and auditors to provide really useful information. One reason why we write so frequently about Quality Financial Reporting is to call on the next generation to make that commitment.

Useful information cannot be generated without it. Yet we see nothing in the words and actions of Wriston or Berardino (or others) that the current generation even acknowledges a connection between financial reporting and truth-telling.

To be sure, the IASB's approach may be more viable in other cultures that still hold managers and accountants personally responsible for their actions. For instance, authorities in many European countries allow fools to fall off scenic overlooks by not putting up unsightly warning signs or fences to protect against the latent danger and reduce litigation risk. (Can you imagine gourmets suing French restaurants for not warning customers that rich food is fattening?)

It's possible that these more advanced cultures might embrace useful financial reporting without detailed rules. The current culture in the U.S. makes this outcome unlikely without a huge change in mindset.

[Note -- the European banking/economic crisis pretty much negated our somewhat optimistic speculation, didn't it? Like managers on our side of the pond, they just couldn't bring themselves to tell the truth about Greek bonds and other bad news.]


Wanted: Leaders with principles!

To ensure we are not misunderstood: We don't see detailed rules as the solution and we don't advocate piling on layers of rules. Like we said, bad guys will be bad, no matter what the system is.

What's needed is a new concept that it's not okay if bad guys become managers and auditors. Things will improve only when the management corps views capital markets like product markets - opportunities to establish mutually beneficial relationships that produce shareholder value.

Following this strategy leads to reporting much more useful information, regardless of the standards. Even if Wriston and Berardino stumbled across a good idea, they can do more for getting it accepted by not advocating it because their tainted pasts are drowning out their words.

They should step aside and let the next generation pursue an entirely different vision that elevates truth-telling above all other strategies for achieving useful reporting.


We recently found this quote by Terence (a Roman poet/pundit of the 2nd century BC who is known for his ironic commentary on his day's politics) that accurately described today's marketplace for management talent: "There is a demand in these days for [those] who can make wrong conduct appear right."

Until there is a groundswell for truth-telling from real leaders in the regulatory, standard-setting, auditing, managing, investing and educating wings of financial accounting and reporting, the capital markets are not going to be well-served.

We remain hopeful, but admit there's not a lot of trustworthy evidence that this movement is underway.


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 paulandpaul@qfr.biz.