Principles-Based Accounting: Wishing Doesn't Make It So

The staff begins by claiming it has a "mandate to study principles-based accounting standards." No, it has a directive from Congress via the Sarbanes-Oxley Act to engage in such a study. This misuse of the word "mandate" presages the ill logic to follow:

Among other things, a principles-based accounting system requires principled people. Given the contemporary shames involving accounting, I think we all know that some actors in the economic system have little or no principles. To work properly, the system must reward those with principles and punish those who abuse and manipulate accounting. As the staff report addresses neither of these issues, at best it reflects naïve thinking by the staff members.

After some preliminaries, the report differentiates rules from principles and introduces a new term: objectives-oriented standard setting. As the cliché says, these differences come with no distinctions.

Be that as it may, one of the most frustrating things about this document is that it merely asserts. It constructs supposition upon supposition and contention upon contention. It would have proved more fruitful if the staff actually tried to demonstrate some of its assertions.

Consider some of the many claims:

Page 13. Objectives-oriented accounting "eschews bright-line tests." Says who? Besides, unless you eliminate all alternatives, some dividing point must exist.
Page 14. Objectives-oriented standards will "avoid the pitfalls that may result in financial engineering to achieve desired accounting pitfalls." What will bring this about -- the good-hearted natures of today's managers and directors?
Page 14. Objectives-oriented accounting will not lose comparability among financial reports "because of management and auditor discretion." Utter nonsense.
Page 28. "The standard setter [needs] to determine the optimal scope of a standard." What proof demonstrates that the scope of any standard has an optimal point? Even if the SEC can prove such an existence, it surely would be a constrained optima. Without the knowledge of what these constraints are and a method to achieve this maximality, what benefit does this new concept produce?
Page 28. The staff returns to the assertion that "opportunities for 'gaming'" will be minimized under an objectives-oriented principles-based accounting. Oh, if it were so!
Page 32. The staff argues against a "true and fair override" as envisioned in Rule 203 of the AICPA Professional Code of Conduct because there will be no need. This allegation can occur only if standards setters perfectly create new accounting standards. Not in my lifetime!
Page 33. "Auditors would need to be weaned away from the check-list mentality." Well, yes and no. They would need to concentrate on the financial reports taken as a whole, as they do now under this despicable rules-based system. Any new principles orientation won't change that, nor will it eliminate the benefits from employing check lists.
Page 34. "Under an objectives-oriented regime, there is a greater incentive for management to ‘tell its story.'" Pray tell us what these incentives are! (Who is writing this staff report -- Woody Allen?)
Page 36. We need a "clear, consistent conceptual framework." Accordingly, the FASB needs to improve its framework. While true, this constitutes a second order concern since there are some inconsistencies. The first order concern is for the FASB to muster the courage to apply the conceptual framework instead of being cowed by Congress and those in management positions that detest the work of the FASB.
Page 37. "The [conceptual] framework does not provide a useful structure or guide as to how these trade-offs [between relevance and reliability] should be made." And nothing you do will alter that situation.
Page 38. "We see the FASB's shift to a more objectives-oriented regime as an integral part of its stated intentions to seek greater convergence between U.S. and international standards." This assertion begs the question of why we should seek convergence, especially given the differences in languages, cultures, monetary systems, and laws. Until you harmonize those things, you can never harmonize accounting. Besides, does anyone except managers desire weaker standards? With this kind of logic, woe to the investment community!
Page 40. "According to IASB Chairman, Sir David Tweedie, in an [sic] principles-based regime, a body such as the EITF should be addressing far fewer [implementation] issues per year than the EITF has historically." In a society as litigious as ours, I don't believe this for a second. Besides, Mr. Tweedie has an agenda which makes his rosy claims suspect.
Page 44. "Rules-based accounting standards exacerbate the problems created by the complexity of business transactions." Maybe, but I would like to see some proof. Even if so, it is at worst a second order concern. The complexity of business transactions explains the overwhelming intricacy found in accounting standards and in financial reports. If the SEC doesn't like this complexity, I suggest that it request Congress to declare these complex transactions illegal.
Page 44. "In contrast, under an objectives-oriented system, the cost to investors and analysts of comprehending the standards themselves should be much lower." Proof? Even if true, it will be counter-balanced by a huge search cost in deciding how firm X, Y, and Z implement the rule in their respective companies. Don't kid yourself that it will be the same. The biggest danger will arise from a false sense of security in knowing how a business enterprise is accounting for certain transactions.
Page 45. There will be "better alignment of professional incentives and mindset with investors' interests." Ha, ha, ha, ha, ha, ha, ha, ha, ha, ha.
Page 46. "Excessively detailed accounting standards not only constitute a guideline to fraud, but a ready-made set of defenses, providing management and accountants with the colorable claim that they followed the rules, even while they may have intended to mislead." Except for some of Enron's activities, I doubt this. The frauds at WorldCom, AOL, Freddie Mac, Global Crossing, Royal Ahold, and HealthSouth do not fit this description at all. What they did clearly violated the rules.
Page 48. "Objectives-oriented accounting standards not only render the standard setting process more timely, but also should improve the quality and consistency of its product." Dear me, does any evidence bolster this argument?
Page 48. "Under an objectives-oriented regime, a greater number of users should be able to grasp the principles at issue, and, thus, they are likely to take the trouble to do so and to participate in the standard setting process." If Vegas sets the odds on this happening, I'll bet against this claim.
Page 49. The staff suggests that rules-based standards setters are more subject to "untoward influences" than those under an objectives-oriented approach. If true, that's only because the principles will be so wishy-washy that the managers won't have to lobby the FASB.

The staff of the SEC might lust for an objectives-oriented principles-based accounting system, but the members offered nothing but suppositions, assumptions, and biases. Without evidence, the report should be ignored.

These concerns are not the only problems with the report. In the next column, I shall take a deeper look at this supposed distinction between rules and standards. In the third of this series, I shall explain why this report looks only at the symptoms of the problems in the world of financial accounting. If real improvements will occur, they will result from dealing with the causes of the problems instead of the symptoms.

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals.

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