ABACUS, Vol. 42, No. 2, 2006

doi: 10.1111/j.1468-4497.2006.00196.x

ABACUS PRINCIPLES ORIGINAL ARTICLE 2 42 © 2006 0001-3072Publishing, Ltd. Abacus UK VERSUS RULES-BASED ACCOUNTING ABA Accounting Foundation, Unviersity of Sydney Oxford, Blackwell

GEORGE J. BENSTON, MICHAEL BROMWICH AND ALFRED WAGENHOFER

Principles- Versus Rules-Based Accounting Standards: The FASB’s Standard Setting Strategy
In response to criticism of rules-based accounting standards and Section 108(d) of the Sarbanes-Oxley Act of 2002, the SEC proposed principlesbased (or ‘objectives-oriented’) standards. We identify several shortcomings with this approach and focus on two of them. First, the format (type) of a standard is dependent on the contents of what the standard regulates. Given the asset/liability approach combined with fair values, we argue that the combination of this measurement concept with principlesbased standards is inconsistent because it requires significant guidance for management judgment. Second, we propose the inclusion of a trueand-fair override as a necessary requirement for any format that is more than ‘principles-only’ to deal with inconsistencies between principles and guidance. We discuss the benefits of this override and present evidence from the United Kingdom’s experience. Key words: Accounting standards; FASB; Principles; Rules; Rules-based.

According to a widely-held view, U.S. accounting standards are more rules-based than principles-based.1 This observation stems in large part from the emphasis put on two aspects of the wording of the typical attestation statement: ‘the financial statements present fairly, in all material respects, the financial position of X Company as of Date, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles [GAAP]’ (emphasis added).2 ‘Present fairly’, which indicates a principles-based approach, is essentially converted to a rules-based approach when it is ‘defined’ in SAS 69
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The papers in this forum adopt varying positions regarding this view. The FASB’s proposed Statement of Financial Accounting Standards, The Hierarchy of Generally Accepted Accounting Principles (FASB, 2005a), would more explicitly codify the rules. It says in para. A5 it expects to ‘reduce the number of levels of accounting literature under the GAAP hierarchy to just two (‘authoritative and non-authoritative . . . [and] integrate GAAP into a single authoritative codification’). The standards adopted by the FASB would be the first level.

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George J. Benston (gjb@bus.emory.edu) is John H. Harland Professor of Finance, Accounting, and Economics, Goizueta Business School, Emory University; Michael Bromwich is the CIMA Professor of Accounting and Financial Management, London School of Economics; and A lfred Wagenhofer is a Professor of Accounting and Management at the University of Graz. We appreciate and benefited from comments by Sudipta Basu, David Cairns, Graeme Dean, Thomas Schildbach and Greg Waymire.

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(.05 a) by reference to Rule 203 of the AICPA Code of Professional Conduct. This rule states that ‘present fairly’ ‘implies that the application of officially established accounting principles almost always results in the fair presentation of financial position, results of operations, and cash flows’.3 GAAP is specified by SAS 69, paragraph AU 411, as a hierarchy of conventions, rules and procedures promulgated by specified authoritative bodies, particularly the Financial Accounting Standards Board and predecessor organizations (e.g., the Accounting Principles Board).4 Thus, if the enumerated and codified GAAP have been followed as specified, presumably the attesting CPAs have done their jobs correctly and adequately in the eyes of the Securities and Exchange Commission and (probably) the Public Company Accounting Oversight Board (PCAOB). Largely because of the Enron Corporation failure, wherein Arthur Andersen was seen as designing or accepting client-originated financial instruments that met the technical requirements of GAAP while violating the intent,5 the rules-based approach has come under fire.6 As a direct result of the misleading accounting procedures revealed in the investigations of Enron’s failure, the Sarbanes-Oxley Act of 2002 included a provision, Section 108(d), instructing the SEC to conduct an investigation into ‘[t]he Adoption by the United States Financial Reporting System of a Principles-Based Accounting System’. The SEC’s Office of the Chief Accountant, Office of Economic Analysis, issued a 68-page Report (the ‘Report’) in July 2003 (SEC, 2003).7 In July 2004, the FASB (2004) responded and in almost
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The AICPA’s Auditing Standards Board proposed amendment to SAS 69 (AICPA Auditing Standards Board, 2005) includes this language. Although the statement includes an ‘almost always’ qualifier, it has not been interpreted to allow for an override. If adopted, SAS 69 applied to non-governmental entities would delete the GAAP hierarchy specified, particularly the statement in paragraph .05 a that gives as the first source—‘Accounting principles promulgated by a body designated by the AICPA Council to establish such principles’— and .05 b which includes: ‘Pronouncements of bodies composed of expert accountants, that deliberate accounting issues in public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted’. These and other sources would be replaced by the FASB, which ‘is responsible for identifying the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States’ (AICPA Auditing Standards Board, 2005, .08). Andersen actually was charged by the Department of Justice with destroying evidence and was found guilty in a jury trial in June 2002 of ‘witness tampering’ because one of its lawyers had ‘corruptly’ persuaded Andersen employees to destroy documents in advance of an SEC investigation. In May 2005 the Supreme Court reversed that conviction, ruling ‘that the jury instructions failed to convey properly the elements of a “corrup[t] persuas[ion]” conviction’ (Arthur Andersen LLP, Petitioner v. United States, No. 04-368, 31 May 2005, Renquist, J., p. 1). The U.S. Department of Justice then chose not to pursue the case. Following a detailed description and analysis of Enron transactions audited or participated in by Andersen, the Examiner in Bankruptcy for Enron (Batson, 2004, Appendix B, p. 167) concludes: ‘The evidence reviewed by the Examiner, and the reasonable inferences that may be drawn from that evidence, are sufficient for a fact-finder to conclude that Andersen was negligent in the provision of its professional services to Enron. In addition, the evidence is sufficient for a fact-finder to conclude that Andersen aided and abetted certain Enron officers in breaching their fiduciary duties to Enron.’ Printed in what the web document describes as the ‘smaller’ text size.

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all respects agreed with the SEC Report (in part, no doubt, because the Report agreed with an earlier FASB [2002] statement and recommended that the FASB be the sole U.S. standard setter).8 Therefore, the Report, which summarizes much of the writing on this subject (including submissions by the FASB), provides a point of departure for an analysis of the ‘rules vs principles’ debate. Given this degree of unanimity and the reasonable presumption that the Commission approved the Report, its analyses and recommendations should be taken very seriously. We begin our analysis by reviewing the SEC’s (2003) Report that suggests a principles-based (or, as it calls it, an objectives-oriented) approach and the subsequent strategy of the FASB with respect to principles-based standard setting. Two major shortcomings are discussed in subsequent sections. First, the format of standards cannot be discussed and decided on without considering the contents of what the standard should prescribe. Observing that the FASB follows the asset/liability approach and increasingly adopts fair-value measurements, we argue that the combination of this measurement concept with principles-based standards is inconsistent. A major reason is that fair values require many rules to provide sufficient guidance, they invite manipulation, and they often cannot be assured by auditors.9 We propose to move back from an asset/liability approach with fair values to the traditional revenue/expense model, which is better able to produce trustworthy and auditable numbers. The second shortcoming is the dismissal of a true-and-fair override that we argue is a necessary requirement for any standard setting approach. The more rules the standards include, the more an override provision is necessary to avoid allowing or even requiring accountants to follow rules by letter but not by intention. The override gives accountants more professional responsibility for financial statement content, and its disclosure gives sufficient transparency for users to understand and, perhaps, challenge its application. We present evidence on the use of a true-and-fair override from the United Kingdom’s experience and discuss how International Financial Reporting Standards (IFRSs) cope with the issue. The format of accounting standards is not exclusively a U.S. issue, although the current debate has emerged there in the aftermath of accounting scandals, but is of international interest because the FASB and IASB have agreed to converge their standards as much as possible. Recent evidence of convergence is their June 2005 joint exposure draft on business combinations (FASB 2005b; IASB 2005a), which has even the same numbering of paragraphs.10 Thus, the U.S. debate on
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Furthermore, the AICPA Auditing Standards Board (2005, p. 5), states that the FASB’s (2005a) proposed statement, The Hierarchy of Generally Accepted Accounting Principles, is ‘[i]n response to recommendations in the [SEC’s Report]’. It is interesting to note that when accounting standards (or principles) were controlled by accounting practitioners who served on AICPA committees, proposals for fair- and present-value restatements of assets were not taken seriously. However, the IASB draft includes less content, so that some paragraphs are ‘not used’ to preserve the consecutive numbering with the FASB draft.

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principles vs rules should not be viewed solely from an U.S. perspective but, rather, from an international one. THE REASONS FOR RULES-BASED STANDARDS In October 2002 the FASB issued a Proposal, Principles-Based Approach to U.S. Standard Setting. The Proposal’s introduction (FASB, 2002, pp. 2–3) explains: ‘in the Board’s view, much of the detail and complexity in accounting standards has been demand-driven, resulting from (1) exceptions to the principles in the standards and (2) the amount of interpretive and implementation guidance provided by the FASB and others for applying the standards’. According to the FASB, the exceptions resulted from the Board having to make compromises with presumably powerful interest groups that prevented it from implementing its desired principles. The Proposal makes particular mention of FAS 133, Accounting for Derivative Instruments and Hedging Activities, the complexities of which resulted from the Board having to make numerous exceptions from the general principles promulgated in FAS 133, para. 3. The extensive guidance, it says, results from having to fulfill the objectives of comparability and verifiability. The Proposal rejects ‘principles-only’ standards, because these ‘could lead to situations in which professional judgments, made in good faith, result in different interpretations for similar transactions and events, raising concerns about comparability’ (p. 9). Comparability may be seen as especially important in an international environment, as there is the danger that local accountants and regulators arrive at differing views on the interpretation of contentious accounting issues. In addition, the FASB (and its predecessors) have developed rules-based standards to meet the demand of major constituents, particularly management and auditors, who want a clear answer to each and every perceivable accounting issue. The litigious situation in the United States (and increasingly in other countries) means that the risk of law suits based on alleged wrong accounting is high and gives accountants a strong incentive to ask for rules they can adhere to in case of a costly law suit. As Schipper (2003) points out, rules are likely to proliferate as accountants ask for guidance that, they hope, will protect them from criticism and lawsuits. Detailed rules and authoritative guidance also serve standard setters’ and regulators’ objective of reducing the opportunities of managers to use judgments to manage earnings (and of auditors to have to accept that practice). Standard setters can be and must show that they are active standard setters. Thus, they may tend to overproduce standards and to write detailed rules covering almost any conceivable situation. THE CASE FOR PRINCIPLES-BASED STANDARDS Despite the demand for rules-based standards, the FASB (2002, 2004) and the SEC (2003) reject them and have turned to proponents of principles-based standards, presumably because in the light of the accounting scandals they consider the costs of rules-based standards to outweigh their benefits. The SEC Report states: 168