A Principled Approach to Accounting Standards

A key issue arising from the business scandals like Enron and Anderson is that U.S. accounting standards are ‘rules-based’, filled with highly specific details in an attempt to address as many potential contingencies as possible. This has made standards bulky and intricate, and has led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavorable reporting. In addition, the quest for accounting rules has shifted the goal of professional judgment from consideration of the best accounting treatment to concern for the letter of the rule.

There are many instances which indicate that the US accounting system is rule-based. Take, for example accounting rules on leasing. SFAS 13 is the primary standard for lease accounting which requires that firms distinguish between operating and capital leases using four specific criteria, whose purpose is to ensure that leases, that are essentially purchases, be treated as purchases. Many companies were structuring their purchases as leases or were entering into lease buy-back transactions, thus relying more on the off-balance sheet transaction. Enter SFAS 13. The FASB (Federal Accounting Standards Board) thought that by providing explicit rules, individual biases and personal judgment would be eliminated and the standards would be applied consistently applied. However the accountant’s found a very easy way to escape the standard in form. The rules were so precise that it became simple to structure leases so as to avoid the transaction falling into financial lease category. For example, the standard might say that a lease should be treated as finance lease if it’s contracted for 80 per cent or more of its life. The result is the accountant would enter into the transaction for 79 per cent of the life and yet escape the standard. Thus now the position is that the standard itself is justifying the transaction as operating lease.

On the other hand, International Accounting Standard 17 (IAS 17) provides broad guidance on classifying lease contracts as capital or operating. The principles-based IAS 17 states simply that a lease “is classified as a finance (i.e. capital) lease if it transfers substantially all of the risks and rewards incident to ownership” to the lessee. IAS 17 does not provide an opportunity to write contracts that avoid minimum requirements. If the substance of the lease is capital, the property must be recorded as an asset and fair value of lease as liability on the lessee’s books. Practically, under IAS 17, it is difficult for companies to write lease contracts that allow off-balance-sheet financing.

But what is a principle-based approach to accounting? In simple terms it aims to, provide underlying principle a to the accountants rather than precise step-by-step rules to meet all possible contingencies. Under a principles-based approach, one starts with building a well-designed framework of good reporting, and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intention is not to try to avoid provideing specific guidance for every possible situation. Rather, in case of unseen situations, the reader is directed back to the principles

Advantages of Principles-Based Accounting

• The principle-based system requires the follower to act in accordance to the ‘spirit’ of a set of broad tenets, rather than the ‘letter’ of a set of explicit rules that can be manipulated.
• The standard setter can prescribe a broad guideline which will apply to all possible situations.
• A principle-based standard will be around 20-25 pages long rather than stretching to 100 pages or more, since it is not required to specify event-based rules.
• Accountants that follow principles will have to use their professionalism instead of a mechanic ‘check-listing’ of the transaction list.

Pitfalls of Principles-Based Accounting

• Comparability of financial statements
• The complexities of an increasingly litigious and regulatory environment
• Problems in industry-specific cases
• Reinventing the wheel
• The need for an appropriate transition

Let’s have a look at the pitfalls:

Comparability

The basic objective of financial reporting is to provide true and fair information to the investing community for evaluating their investment. The information will be true and fair if it is relevant, reliable, and comparable across reporting periods and entities. The problem arises because the terms ‘reliable’ and ‘comparable’ are not complimentary. When the standards are principle-based and not rule-based, the problem of individual judgment arises, and if you try to make two reports comparable the standards become rule based. There may be a significant increase in divergence, however, if the board conceptualizes a principles-based standard at too high a level.

Litigious and Regulatory Environment

There will be instances which do that do not fit into the definitions or situations prescribed in the standards. This situation might arise as a result of technological changes or due to complexities and innovations in business transactions or financial engineering. In such cases where the matters have been reached the courts there might be difficulties in interpreting the standard.

Need for Industry-Specific Guidance

There will continue to be a need for industry-specific accounting guidance even under principles-based standards. It is a known fact that the transactions involved in the insurance and banking industries are typical in nature and these kind of transactions might require explicitly specific and clear treatment.

Reinventing the Wheel

The accountants and auditors may need different levels of implementation guidance. For example, the effort required to think through an implementation issue may not be an unreasonable burden on large auditing firms because they have the necessary manpower and resources to do so. That same effort will be onerous for a smaller firm and will lead to inconsistencies in practice and wasted efforts attempting to ‘reinvent the wheel’.

Conclusion

This discussion leaves the standard setters between Scylla and Charybdis. If the standards are rule-based they can be evaded by careful structuring of the transactions and if they are principle-based there are issues like comparability and individual biases. Perhaps the accounting boards have to take a midway “Let the standards be primarily principle based but provided minimum guidelines so that they cannot be misinterpreted or misused”.