 |
Home | Previous Page | |
|
||
 |
|
|
|
||
 |
|
|
|
|
|||||||||||||||
|
|
|||||||||||||||
|
|
Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting SystemSubmitted to Committee on Banking, Housing, and Urban Affairs of the United States Senate and Committee on Financial Services of the United States House of RepresentativesOffice of the Chief Accountant
|
| AAA | American Accounting Association |
| AAER | Accounting and Auditing Enforcement Release |
| AcSEC | Accounting Standards Executive Committee of the American Institute of Certified Public Accountants |
| AIA | American Institute of Accountants |
| AICPA | American Institute of Certified Public Accountants |
| APB | Accounting Principles Board |
| ARB | Accounting Research Bulletin |
| ASR | Accounting Series Release |
| AU | Codification of Auditing Standards |
| Commission | United States Securities and Exchange Commission |
| Committee | Committee on Accounting Procedure |
| DIG | Derivatives Implementation Group |
| EC | European Commission |
| EITF | Emerging Issues Task Force |
| FAF | Financial Accounting Foundation |
| FASB | Financial Accounting Standards Board |
| FEI | Financial Executives International |
| FSP | FASB Staff Position |
| GAAP | Generally Accepted Accounting Principles |
| IAS | International Accounting Standard |
| IASB | International Accounting Standards Board |
| IASC | International Accounting Standards Committee |
| IFRS | International Financial Reporting Standard |
| IMA | Institute of Management Accountants |
| MD&A | Management's Discussion and Analysis |
| PCAOB | Public Company Accounting Oversight Board |
| SAB | Staff Accounting Bulletin |
| SAS | Statement on Auditing Standards |
| SEC | United States Securities and Exchange Commission |
| SFAC | Statement of Financial Accounting Concepts |
| SFAS | Statement of Financial Accounting Standards |
| SOP | Statement of Position |
The Sarbanes-Oxley Act of 2002 ("the Act") sought, among other things, to improve our system of financial reporting by reinforcing the checks and balances that are critical to investor confidence. Additionally, Congress recognized that questions remain regarding the approach by which accounting standards are established. As directed by the Act, we have conducted a study of the approach to standard setting and found that imperfections exist when standards are established on either a rules-based or a principles-only basis. Principles-only standards may present enforcement difficulties because they provide little guidance or structure for exercising professional judgment by preparers and auditors. Rules-based standards often provide a vehicle for circumventing the intention of the standard. As a result of our study, the staff recommends that those involved in the standard-setting process more consistently develop standards on a principles-based or objectives-oriented basis. Such standards should have the following characteristics:
The Act requires changes in many facets of the financial reporting by and analysis of companies. Some of the important changes being implemented and studies being undertaken under the direction of the Act are: (1) required certification of information by company CEOs and CFOs, (2) empowerment of audit committees to engage and approve the services provided by independent auditors, (3) more stringent auditor independence standards, (4) greater oversight of auditors through the establishment of the Public Company Accounting Oversight Board, (5) a study of whether investment banks played a role in the manipulation of earnings by some public companies, and (6) greater independence for the accounting standard setter. Additionally, as noted above, the Act directed the Securities and Exchange Commission ("SEC") to conduct a study on the adoption by the United States financial reporting system of a principles-based standard setting process and to submit a report thereon to Congress. This study is intended to fulfill that mandate.
In the staff's view, U.S. generally accepted accounting principles ("GAAP"), despite being the historical product of a mixture of standard setting approaches, constitutes the most complete and well developed set of accounting standards in the world. These standards vary significantly in their level of detail, adherence to a conceptual framework, and reliance on objectives and rules. While it has become fashionable recently to refer to principles-based and rules-based standards, these categories are not well defined and, therefore, are subject to a wide variety of interpretations. To conduct a study of the adoption of principles-based standard setting in the U.S., we first had to provide a clear definition of the optimal type of principles-based accounting standards and to distinguish it from other approaches.
We chose to base the study on what we considered to be the optimal type of principles-based accounting standards because we believe that Congress' intent was to have the staff consider whether a different standard-setting paradigm from the one that exists today would be beneficial to U.S. investors. We believe that neither U.S. GAAP nor international accounting standards, as currently comprised, are representative of the optimum type of principles-based standards. Defining what we believe to be the optimal paradigm provides a necessary framework for this study.
In our minds, an optimal standard involves a concise statement of substantive accounting principle where the accounting objective has been included at an appropriate level of specificity as an integral part of the standard and where few, if any, exceptions or conceptual inconsistencies are included in the standard. Further, such a standard should provide an appropriate amount of implementation guidance given the nature of the class of transactions or events and should be devoid of bright-line tests. Finally, such a standard should be consistent with, and derive from, a coherent conceptual framework of financial reporting.
To distinguish this study's vision of the optimal approach from less formally defined approaches proposed by others, we refer to our approach as "objectives-oriented" standard setting. We do occasionally refer to principles-based standard setting in the study, by which we mean standard setting approaches that approximate the objectives-oriented approach we have defined. This study concludes that objectives-oriented standard setting is desirable and that, to the extent U.S. standard setters have not already done so, the benefit of adopting this approach in the U.S. should justify the costs.
In contrast to objectives-oriented standards (as we have defined the term), rules-based standards can provide a roadmap to avoidance of the accounting objectives inherent in the standards. Internal inconsistencies, exceptions and bright-line tests reward those willing to engineer their way around the intent of standards.2 This can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events. In a rules-based system, financial reporting may well come to be seen as an act of compliance rather than an act of communication. Additionally, because the multiple exceptions lead to internal inconsistencies, significant judgment is needed in determining where within the myriad of possible exceptions an accounting transaction falls.
At the other extreme, a principles-only approach (which some have suggested as the meaning of the term principles-based accounting standards) typically provides insufficient guidance to make the standards reliably operational. As a consequence, principles-only standards require preparers and auditors to exercise significant judgment in applying overly-broad standards to more specific transactions and events, and often do not provide a sufficient structure to frame the judgment that must be made.3 The result of principles-only standards can be a significant loss of comparability among reporting entities. Furthermore, under a principles-only standard setting regime, the increased reliance on the capabilities and judgment of preparers and auditors could increase the likelihood of retrospective disagreements on accounting treatments. In turn, this could result in an increase for both companies and auditors in litigation with both regulators and the plaintiffs' bar.
In contrast to these extremes, objectives-oriented standards explicitly charge management with the responsibility for capturing within the company's financial reports the economic substance of transactions and events-not abstractly, but as defined specifically and framed by the substantive objectives built into each pertinent standard. In turn, auditors would be held responsible for reporting whether management has fulfilled that responsibility. Accordingly, objectives-oriented standards place greater emphasis on the responsibility of both management and auditors to ensure that the financial reporting captures the objectives of the standard than do either rules-based standards or principles-only standards. Further, if properly constructed, we believe objectives-oriented standards may require less use of judgment than either rules-based or principles-only standards, and thus, may serve to better facilitate consistency and compliance with the intent of the standards.
Fundamental to this approach is that the objectives-oriented standards, as defined herein, would clearly establish the objectives and the accounting model for the class of transactions, providing management and auditors with a framework that is sufficiently detailed for the standards to be operational. At the same time, if constructed with the optimal level of detail, such standards would provide users, as well as regulators and others who oversee or monitor the financial reporting process, with sufficient detail to better comprehend and properly gauge the results reported by management and attested to by the auditors. Further, because objectives-oriented standards provide a better framework in which to exercise professional judgment than do either rules-based or principles-only standards, they may serve to better facilitate compliance with the intent of the standards.
In this manner, an objectives-oriented approach should provide the means by which management and auditors may be held accountable for reporting the substance of transactions within the financial statements. We believe that this responsibility-to ensure the fulfillment of specific, substantive accounting objectives-more effectively aligns the interests of management and auditors with those of investors, than do either a rules-based approach or a principles-only approach. As a consequence, we conclude that an objectives-oriented approach should ultimately result in more meaningful and informative financial statements.
In addition, and importantly, under an objectives-oriented system, the cost to investors and analysts of comprehending the standards themselves is expected to be lower. Indeed, ideally, an investor or analyst would obtain a reasoned conceptual understanding of the meaning of reported numbers by studying the stated objective of the pertinent standards. That is, under an objectives-oriented regime, each standard's stated objective assists the user in comprehending how the standard is constructed, how it is to be applied to a class of transactions or events, and how those transactions or events should be reflected in the company's financial statements.
Another benefit of objectives-oriented standards is that they may serve to enhance the quality, consistency, and timeliness of the standard setting process itself. With today's faster pace of change, timeliness in the development of accounting standards has become increasingly important. Under an objectives-oriented regime, standard setters should be able to move faster to address emerging practice issues while still providing sufficient guidance so that the standards are operational.
An additional benefit is the facilitation of greater convergence between U.S. GAAP and international standards. Standard setters can come to an agreement on a principle more rapidly than they can on a highly detailed rule. The benefits of convergence include greater comparability and improved capital formation globally. We believe that neither current U.S. GAAP nor the current array of international standards strike an optimal balance in the various trade-offs inherent in standard setting, and thus we see convergence as a process of continuing discovery and opportunity to learn by both U.S. and international standard setters.
Other issues relevant to an economic analysis of an objectives-oriented approach are explored in the body of the study. These include: costs of accounting services, comparability issues, certain transition costs, and litigation uncertainty.
We believe, however, that the concern over litigation uncertainty is sometimes overstated and may arise out of a confusion between principles-based and principles-only standards. If preparers and auditors maintain contemporaneous documentation that demonstrates that they properly determined the substance of a covered transaction or event, applied the proper body of literature to it, had a sound basis for their conclusions-particularly those involving the exercise of judgment-and ensured through disclosure that their method was transparent, their exposure to litigation may be reduced.
While we conclude that the benefits of adopting objectives-oriented or principles-based standards in the U.S. justify the costs, the magnitude of these benefits and costs are extremely difficult to assess. Indeed, a study of the relative merits of adoption by the U.S. financial reporting system of principles-based accounting standards, as mandated by the Act, does not lend itself to a direct empirical test prior to its adoption and implementation. Moreover, the work of balancing the various trade-offs inherent in standard setting is an on-going process of discovery with many participants. Indeed, we would not expect these trade-offs to carry the same weights from one accounting issue to the next. In light of these challenges, the focus of our economic analysis has been to identify the most important trade-offs in setting accounting standards that relate to the application of principles versus rules. The study, while being directional and conceptual in nature, is informed through both economic analysis and accounting experience.
As such, this study is a policy study. In it, we will be characterizing certain existing U.S. GAAP standards and, at least implicitly, criticizing the manner in which some standards are currently structured and formulated. We do this to fulfill a legislative mandate. Nonetheless, nothing in this study should be construed as indicating a belief by the staff that any current U.S. GAAP standard is lacking in terms of providing sufficient structure, guidance, and consistency to hold preparers and auditors accountable and to be enforceable, as we do not believe that to be the case. Recognition that there is room for improvement to the standards should not be confused with a suggestion that current standards are inadequate. As noted above, we believe that the current U.S. standards are the most complete and well developed set of accounting standards in the world.
As we will demonstrate, U.S. standard setters have begun the shift to objectives-oriented standard setting and are doing so on a prospective, project-by-project basis. We expect that the U.S. standard setters will continue to move towards objectives-oriented standard setting on a transitional or evolutionary basis. Operationalizing an objectives-oriented approach to standard setting in the U.S. requires the standard setters to undertake the following key steps, which are explored in more detail in this report:
The following table outlines the key steps required for the U.S. standard setting process to move to a more objectives-oriented approach.
| Action Items | Current Status | Time Horizon |
| Conceptual framework improvements project | FASB currently evaluating most efficient approacha | Medium Term |
| Move towards objectives-oriented form of standards | Recent standards (e.g., SFAS No. 141 and following) have included elements of objectives-oriented form | Immediate |
| Comprehensive review of current standards to identify and address those that are rules-based | SFAS No. 141 superseded APB Opinion No. 16 (rules-based); accounting for stock-based compensation added to FASB agenda on March 12, 2003; staff and Board are evaluating existing standards for purposes of future agenda decisions | Underway |
| One standard setterb | AcSEC will no longer be responsible for issuing "authoritative" standards, transition plan is in place; EITF consensuses now are subject to FASB approval | Underway |
| Redefine GAAP hierarchy | Conceptual framework improvements project to be completed first | Medium term |
| Convergence | In October 2002, FASB and IASB jointly announced intention to work towards convergence of international and domestic standards. Joint or cooperative projects underway include business combinations, measuring financial performance, stock-based compensation, revenue recognition, and short-term convergencec | Underway, some standards expected to be issued within the next year, but effort will be long term |
The recent spate of major corporate accounting scandals suggested to many that our system of corporate governance and financial reporting is in need of improvement. To many it appears that, at least in some cases, the checks-and-balances within the financial reporting system-ranging from management to auditors, audit committees, boards of directors, analysts, rating agencies, corporate counsel, standard setters, regulators and the investors themselves-failed to prevent or detect large-scale fraud in major corporations which were carried out over extended periods of time. While we believe the financial reporting system remains fundamentally sound, and, generally, of the highest quality, these failures were a call for action.
Congress responded by passing the Sarbanes-Oxley Act of 2002 ("the Act"),1 the most significant piece of securities legislation since the 1930s. Much of the Act may be viewed as a legislative attempt to better align the incentives of management, auditors and other professionals with those of investors. For example, with respect to corporate management, the Act increased penalties2 for violations of securities laws and required certification of financial results by key corporate officers. With respect to auditors, the Act directed the Commission to establish rules prohibiting auditors from the provision of certain non-audit services to audit clients and rules to strengthen oversight of the audit process by audit committees. Additionally, it called for increased resources for inspection, review and enforcement with respect to auditors through the creation of the Public Company Accounting Oversight Board ("PCAOB").
In sum, the Act called for improvement in the checks-and-balances that govern the production of financial information provided to investors and, thereby, served notice on bad actors that they would be discovered and dealt with for their misrepresentations. But the logical question loomed as to whether these actions addressed completely the causes of these financial scandals. Many asked whether, beyond the bad actors, the accounting standards themselves might have played some role in facilitating or even encouraging the bad behavior. More generally, many asked whether technical compliance with U.S. accounting standards necessarily results in financial reporting that fairly reflects the underlying economic reality of reporting entities.
Among these concerns, there was a growing sense that the standard setting process in the U.S. may have become overly rules-based. Three of the more significant and commonly-accepted shortcomings of rules-based standards are that they:
Accordingly, Section 108(d) of the Act calls upon the staff of the Securities and Exchange Commission ("Commission" or "SEC") to conduct a study on the adoption by the United States financial reporting system of a principles-based accounting system and for the Commission to submit a report thereon to Congress by July 30, 2003.3 The Act mandates that the study shall include: (i) the extent to which principles-based accounting and financial reporting exists in the United States;4 (ii) the length of time required for change from a rules-based to a principles-based financial reporting system;5 (iii) the feasibility of and proposed methods by which a principles-based system may be implemented;6 and (iv) a thorough economic analysis of the implementation of a principles-based system.7 This study responds to these mandated inquiries.
The objectives of financial reporting are to provide information that is useful to investors and creditors8 in their decision-making process.9 In order for the financial reporting process to be successful-that is, for the objectives to be accomplished-many participants play important roles. Among the participants whose roles are critical to the success of the financial reporting process are company management, audit committees, external auditors, analysts and investment advisors, investors, regulators and oversight bodies, and accounting standard setters. The Act requires changes by many participants in the financial reporting. Some of the important changes being implemented and studies being undertaken under the direction of the Act are: (1) required certification of information by company CEOs and CFOs, (2) empowerment of audit committees to engage and approve the services provided by independent auditors, (3) more stringent auditor independence standards, (4) greater oversight of auditors through the establishment of the PCAOB, (5) a study of whether investment banks played a role in the manipulation of earnings by some public companies, and (6) greater independence for the accounting standard setter.
To study the implications of principles-based standards, it is necessary to consider the entire context of financial reporting in the time period subsequent to the enactment of the Act. Stated differently, the standard setting approach is but one element of the reforms put in motion by the Act. Thus, an evaluation of the potential effectiveness of a principles-based approach to standard setting must be made within the context of these other reforms.10
In particular, the reforms of the Act require management to accept responsibility for ensuring that the financial information provided to investors fairly presents the company's financial position, results of operations, and cash flows. Additionally, management is required to ensure that it has proper disclosure controls in place so that the company will be able to provide clear and transparent disclosure to investors of all material information.
Furthermore, through the PCAOB, the audit process and auditors will be more closely scrutinized. As the evaluation of auditors shifts from one of "peer review" to that of PCAOB inspection, it will place an additional premium on the auditors' ability to evaluate both compliance with generally accepted accounting principles ("GAAP") and the adequacy of a company's disclosures in light of the underlying economic substance of the company's transactions.
To conduct a study of the adoption of principles-based standard setting in the U.S., we must first define principles-based. There are a wide variety of views on the meaning of that term. Accordingly, we have defined principles-based standards below in a manner consistent with what we would view as optimal adjustments to U.S. standards in this direction. This approach allows us to analyze such a shift with a reasonable degree of specificity.11
In our view, the optimal principles-based accounting standard involves a concise statement of substantive accounting principle where the accounting objective has been incorporated as an integral part of the standard and where few, if any, exceptions or internal inconsistencies are included in the standard. Further, such a standard should provide an appropriate amount of implementation guidance given the nature of the class of transactions or events and should be devoid of bright-line tests. Finally, such a standard should be consistent with, and derive from, a coherent conceptual framework of financial reporting.
To distinguish our vision of a principles-based approach to standard setting from those proposed by others, we refer to it as objectives-oriented standard setting. Standards established in such a fashion are objectives-oriented in a number of senses.
First, in applying a particular standard in practice, preparers (and auditors) are required to focus the accounting (and attestation) decisions on fulfilling the accounting objective of that standard. This minimizes the opportunities for financial engineering designed to evade the intent of the standard.
Second, each standard is drafted in accordance with objectives set by an overarching, coherent conceptual framework meant to unify the accounting system as a whole.
Third, this approach eschews exceptions, which by their very nature are contrary to fulfilling a principled objective, create internal inconsistencies within the standard, and, inherently, create a need for more detailed guidance.
Fourth, it also eschews bright-line tests, which often are a product of the exceptions. These are inherently contrary to any principled objective, because a slight shift in the form or structure of a transaction can cause it to move across the threshold resulting in profoundly different accounting for transactions that are economically similar.
Finally, objectives-oriented standards clearly articulate the class of transactions to which they apply and contain sufficiently-detailed guidance so that preparers and auditors have a structure in which to determine the appropriate accounting for the company's transactions. In general, the possible degrees of specificity to which accounting standards may be drafted constitute a spectrum ranging from the abstract, at one end, to the very specific at the other. Objectives-oriented standards, when properly constructed, land solidly between the two ends of this spectrum.12
Objectives-oriented standards stand in contrast to rules-based accounting standards, which are characterized by bright-line tests, multiple exceptions, a high level of detail, and internal inconsistencies. The vision underlying a rules-based approach is to specify the appropriate accounting treatment for virtually every imaginable scenario, such that the determination of the appropriate accounting answer for any situation is straight-forward and, at least in theory, the extent of professional judgment necessary is minimized. Ironically, however, significant application of judgment remains necessary in a rules-based environment. The focus of that judgment, however, is not on capturing the economic substance of the transactions or events, but rather it is shifted to the determination of which of the accounting treatments within a complex maze of scope exceptions and often conflicting guidance is applicable.
An argument in support of the use of bright-line tests that are endemic to rules-based accounting standards is that the tests result in greater comparability across issuers since all are applying the same bright-lines. However, contrary to these beliefs, rules-based standards often create only illusory comparability because transactions falling just barely on opposite sides of the bright-line are generally very similar, but receive very different accounting treatments.
Unfortunately, experience demonstrates that rules-based standards often provide a roadmap to avoidance of the accounting objectives inherent in the standards. Internal inconsistencies, exceptions and bright-lines tests reward those willing to engineer their way around the intent of standards. This can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events. In a rules-based system, financial reporting may well come to be seen as an act of compliance rather than an act of communication. Moreover, it can create a cycle of ever-increasing complexity, as financial engineering and implementation guidance vie to keep up with one another.
Objectives-oriented standards also stand in contrast to what we refer to as principles-only (as contrasted with principles-based) standard setting, which might be defined as high-level standards with little if any operational guidance.13 A principles-only approach often provides insufficient guidance to make the standards reliably operational. As a consequence, principles-only standards typically require preparers and auditors to exercise judgment in accounting for transactions and events without providing a sufficient structure to frame that judgment.14 The result of principles-only standards can be a significant loss of comparability among reporting entities.
In contrast to these extremes, objectives-oriented or principles-based standards charge management with the responsibility for capturing within the company's financial reports the economic substance of transactions and events-not abstractly, but as defined specifically and framed by the substantive objectives built into each pertinent standard. In turn, auditors would be held responsible for reporting whether management fulfilled that responsibility. Accordingly, objectives-oriented standards impose a greater responsibility on both management and auditors than do either rules-based standards or principles-only standards. Further, if properly constructed, objectives-oriented standards may require less use of professional judgment than either rules-based or principles-only standards, and thus, may serve to better facilitate efforts to enforce compliance with the standards.
Fundamental to this approach is that the objectives-oriented standards would clearly establish the objectives and the accounting model for the class of transactions, providing management and auditors with a framework that is sufficiently detailed for the standards to be operational. At the same time, such standards would provide users, as well as regulators and others who oversee or monitor the financial reporting process, with sufficient detail to comprehend and properly gauge the results reported by management and attested to by the auditors. In this manner, an objectives-oriented approach should provide the means by which management and auditors may be held accountable for reporting the substance of transactions within the financial statements.
Thus, on the one hand, objectives-oriented standards are superior to rules-based standards, because they avoid the pitfalls that may result in financial engineering to achieve desired accounting results. On the other hand, objectives-oriented standards are superior to principles-only standards, because they provide sufficient structure for preparers and auditors to make a determination of the appropriate accounting. As a consequence, we believe financial reporting based on objectives-oriented standards strikes an optimal balance and should increase both comparability and transparency of information as compared to either a principles-only approach or a rules-based approach to standard setting.
Some of the concerns that have been expressed about principles-based standards include: (1) a loss of comparability because of management and auditor discretion in the application of the principles, (2) a greater difficulty in seeking remedies against "bad" actors either through enforcement or litigation, and (3) a concern by preparers and auditors that regulatory agencies might not accept "good faith" judgments.15 However, these concerns seem more founded as a critique of principles-only standards. Indeed, it is for these very reasons that we reject principles-only standards as an optimum standard setting paradigm.
In contrast to a principles-only approach, the framework for the application of professional judgment in an objectives-oriented regime is much narrower and provides a basis for more informative financial information to be provided to investors.16 Indeed, properly constructed objectives-oriented standards have the potential to improve "actual" comparability as compared to either a rules-based or a principles-only approach,17 since the application of an objectives-oriented standard is more likely to reflect the underlying economic substance of transactions or events, while the range within which professional judgment must be exercised is narrowed as compared to either a principles-only or a rules-based approach.18 Indeed, with management and auditors held accountable for fulfilling the narrowly circumscribed substantive accounting objectives built into objectives-oriented standards, we believe that the degrees of freedom to achieve "desired" accounting results is minimized-relative to either a rules-based or a principles-only approach.19
Regardless of the approach that standard setters take to establishing accounting standards, there are, inevitably, many interpretive actions taken by management and the auditors in preparing and attesting to a company's financial statements. Indeed, the process of preparing the company's financial statements essentially constitutes a translation of economic reality into an accounting framework as defined by a set of standards. Likewise, attesting to the appropriateness of those financial statements requires the auditor to make an informed judgment as to whether the financial statements are representative of that economic reality, in accordance with a set of standards. This interpretive process necessarily involves judgment. By changing the focus of professional judgment to the objectives of the accounting standard, objectives-oriented standards allow accounting professionals to operationalize accounting treatments in a manner that best fulfills the objective of each standard and thereby best captures the underlying economic reality.
In contrast, inherent in a rules-based approach is an intent to minimize (and indeed in certain instances to trivialize) the judgmental component of accounting practice through the establishment of complicated, finely articulated rules that attempt to foresee all possible application challenges.20 Unfortunately, this belief that judgment can be minimized or eliminated is a mistake for at least three reasons.
First and foremost, no standard setter can ever sufficiently identify the myriad of business situations to which accounting standards must be applied. As a consequence, it is virtually impossible for standard setters to construct accounting categories with sufficient refinement so as to be optimal for each and every situation encountered. Indeed, the more rigid and detailed accounting standards are, the less well they may fit the unforeseen specific facts associated with individual reporting companies' circumstances. In contrast, objectives-oriented accounting standards should provide a better balance of structure and flexibility that affords management and accountants the opportunity, and gives them the responsibility, to interpret company-specific facts in the manner that best conveys the underlying economic reality to investors.
Second, excessively detailed accounting standards fail to take advantage of the company-specific knowledge of the front-line professionals-management, accountants, audit committee members, and auditors-who are making the accounting judgments. Managements have access to much information that is crucial for quality financial reporting. Excessive efforts by standard setters to eliminate judgment sacrifice valuable information that might otherwise be offered by the most informed parties. Accounting standards must incorporate some flexibility within their structure-as do objectives-oriented standards-to best facilitate the capture of such knowledge.
Finally, it is simply impossible to fully eliminate professional judgment in the application of accounting standards.21 To pretend that standards can be written in such a manner results in both unnecessary cost and a misplaced regulatory focus. No set of ever more complicated rules can substitute for the essential ingredients to the reporting process of professional integrity and accountability. Furthermore, as noted earlier, because of the exceptions and internal conflicts inherent in a rules-based system of accounting standards, judgment is not eliminated at all. Rather, the judgment shifts to a determination of which part of the contradictory rules should be applied.22
An evaluation of the potential effectiveness of an objectives-oriented standard setting approach must be made within the context of the other reforms associated with the Act. In particular, the reforms of the Act require management to accept responsibility for ensuring that the financial information provided to investors fairly presents the company's financial position, results of operations, and cash flows. Additionally, management is required to ensure that it has proper disclosure controls in place so that the company will be able to provide clear and transparent disclosure to investors of all material information. Furthermore, through the PCAOB, the audit process and auditors will be more closely scrutinized. As the evaluation of auditors shifts from one of "peer review" to that of PCAOB inspection, it will place an additional premium on the auditors' ability to evaluate both compliance with GAAP and the adequacy of the company's disclosures in light of the underlying economic substance of the company's transactions. These changes coupled with greater empowerment of audit committees to engage and approve the services provided by independent auditors, more stringent auditor independence standards, and substantial penalties for violations23 provide the context for an evaluation of objectives-oriented standard setting. Thus, the other reforms from the Act serve to re-inforce the incentives of management and auditors to provide more informative financial reporting.
The reforms associated with the Act are highly complementary to objectives-oriented standard setting. While objectives-oriented accounting standards hold preparers and auditors to a heightened degree of responsibility for the fulfillment of substantive, clearly-defined accounting objectives, the Act provides for the heightened monitoring and accountability that ensures most will be motivated to do so. For example, management certifications could be more meaningful when combined with objectives-oriented accounting standards, as the goal of fair presentation of results would underly the objectives upon which standards are built. And while no regime can preclude fraud, we believe that objectives-oriented accounting standards also may better align the incentives of those who produce financial information with the interests of investors, which should result in more informative financial information. This, above all, is the underlying goal of the Act. Without the other reforms associated with the Sarbanes-Oxley Act, the potential benefits of objectives-oriented standards would be lower, while the associated costs would be higher.
Many contend that U.S. GAAP provides an example of a rules-based approach to standard setting. However, we do not fully agree. While we agree that certain standards do suffer from the short-comings of a rules-based approach, many others are closer to the kind of principles-based approach we prescribe herein. Moreover, U.S. GAAP already is based on an explicit conceptual framework, albeit one in need of improvement.
That being said, we do take certain standards currently extant in the U.S. accounting literature as examples of rules-based standards. These include standards on derivatives, leases, and stock compensation. Many believe that these standards, which will be discussed in more detail later in this report, are far from the optimal point on the spectrum and would benefit from an objectives-oriented standard setting approach.
Many have pointed to International Financial Reporting Standards ("IFRSs"),24 issued by the International Accounting Standards Board ("IASB") and selected for adoption in Europe by the European Commission ("EC"),25 as an example of a principles-based regime. We do not believe the line of demarcation to be quite so simple. As they currently stand, the IFRSs do not embody the objectives-oriented approach to principles-based accounting standard setting. Indeed, a careful examination of the IFRSs shows that many of those standards are more properly described as rules-based. Other IFRSs could fairly be characterized as principles-only because they are overly general.26 Accordingly, we reject the notion that IFRSs constitute a model for principles-based accounting standards.
One conclusion of this study is that the existence of numerous exceptions and voluminous detailed guidance, as characterizes a rules-based standard, often leads to inconsistencies in the application of the standard Such standards may contain conflicting guidance and, because preparers and auditors may have different interpretations about which application of the literature is appropriate, there can be inconsistent accounting among companies for similar transactions.27 Moreover, the bright-line tests that demarcate the exceptions provide a roadmap for financial engineers to achieve desired accounting results. A consequence of such financial engineering is that transactions that are substantively the same may receive very different accounting. Some have argued that rules-based standards help achieve greater comparability in reporting. In reality, because of the inherent inconsistencies and bright-lines, comparability in reporting can be illusory.
To illustrate, consider an example of accounting for a business combination.28 Accounting Principles Board ("APB") Opinion No. 16 concluded that both the pooling of interests method and the purchase method were appropriate methods in accounting for business combinations. However, in reaching that conclusion, the APB specified 12 criteria, all of which must be met, in order for a combination to be accounted for as a pooling of interests.29 A combination that failed to meet one or more of those criteria was accounted for as a purchase.30 These criteria were almost all bright-line tests. For example, if a company acquired 90% of another company through an exchange of stock, pooling of interests was possible, but if it acquired only 89%, pooling was not possible. Pursuant to another test, the issuance of one share of restricted stock to an employee during certain periods could turn a transaction from a pooling to a purchase.
The purchase method and the pooling of interests method yield dramatically different financial reporting results. The purchase method reflects the business combination at fair value-that is, the amount paid by the acquiring company-while the pooling of interests method relies on book value. Because of this dramatic difference in reporting, financial engineers were sometimes eager to structure combinations in a manner that met the pooling of interests requirements. Inevitably, this led to a demand for increased guidance on the application of the pooling of interests criteria, which, in turn, led to increasingly complex and detailed guidance. Nonetheless, because of the significant difference in financial reporting under the two methods, companies often were willing to incur the cost and effort needed to navigate the difficult path to achieve a desired accounting result (pooling of interests)-despite the fact that the basic transaction, the combination of two entities, was not altered by the accounting method.
Consider a numerical illustration. Assume that Company A acquires Company B through the exchange of voting stock. The value of the exchange to Company A is $1,000 and the book value of Company B's net assets is $400. Further, assume that in the first year after the acquisition, Company B has net income of $300 (based on Company B's underlying book value). Let us also assume that the $600 difference between Company B's book value and the fair value of the combination is attributable to identifiable assets that are depreciated or amortized over six years. Under the pooling of interests method, the income that would be reported from Company B's operations would be $300. If, however, the combination were reported as a purchase, the income that would be reported from Company B's operations would be $200 ($300 minus $100 of additional depreciation/amortization). In either case, however, the related cash flows and economic value of Company B's operations to Company A would be the same.
Thus, the presence of the pooling of interests alternative, and the rules associated with it, rendered illusory the comparability in financial reporting for business combinations. Obviously, the underlying economic reality for a given transaction was the same regardless of whether the transaction was accounted for as a pooling of interests or a purchase. Nonetheless, there is evidence to suggest that investors' assessments of the company were affected by the difference in reporting.31
Section II of this study provides the historical background to accounting standard setting in the U.S., including a description of the current conceptual framework and the roles of the various participants in the standard setting process. Section II also details the current status of U.S. standards with respect to the extent to which they might be deemed as principles-based or, alternatively, rules-based.
Section III covers the components of an objectives-oriented principles-based approach to standard setting.
Section IV covers the practical issues raised in the implementation of an objectives-oriented principles-based approach to standard setting.
Section V provides the economic and policy analysis of adopting objectives-oriented standards in the U.S. The issues that bear on this analysis are: improved accessibility to and informativeness of financial information for investors; better alignment of preparer and auditor incentives with investors' interests; enhanced quality, consistency and timeliness of standard setting; the provision of a vehicle for convergence with international accounting standards; cost of accounting services; comparability issues; litigation uncertainty, and transition costs.
Section VI provides the conclusion, and includes a chart that provides time horizons for the various action items necessary to continue a movement in the direction of principles-based accounting standard setting in the U.S.
i. Development of Promulgated Standards
The Commission has the authority to establish accounting principles to be used in financial statements filed with the Commission.32 Additionally, the Commission has made clear that financial statements filed with the Commission should not be misleading to investors. In that regard, the Commission has stated in Accounting Series Release ("ASR") No. 4:
In cases where financial statements filed with the Commission pursuant to its rules and regulations under the Securities Act or the Exchange Act are prepared in accordance with accounting principles for which there is no substantial authoritative support, such financial statements will be presumed to be misleading or inaccurate despite disclosures contained in the certificate of the accountant or in footnotes to the statements provided the matters involved are material.33
While ASR No. 4 made clear that only accounting principles having "substantial authoritative support" would be appropriate for inclusion in financial statements filed with the Commission, the question at hand was what body should be responsible for establishing such principles. The Commission's first Chief Accountant, Carman G. Blough, stated that if the profession wanted to retain the ability to determine accounting principles and methods, it would be up to the profession to issue statements of principles that could be deemed by the Commission to have "substantial authoritative support."34
In response to this challenge to the profession, the American Institute of Accountants35 ("AIA") gave to its Committee on Accounting Procedure ("Committee") the responsibility for establishing accounting principles and the authority to speak on behalf of the Institute on matters of accounting principles. It was intended that the Committee would serve as the principal source of "substantial authoritative support" for accounting principles.
From 1939 to 1959, the Committee issued a series of Accounting Research Bulletins ("ARBs") intended to establish "substantial authoritative support" on a variety of issues. While the Committee had some success in narrowing divergence in practice on certain issues, it ultimately was unable to develop a set of principles that could serve as the basis or framework for establishing specific standards. This resulted in a standard-setting process often described as piece-meal, since its standards were not based on a consistent, underlying theme or framework. Additionally, there were ongoing challenges to the Committee's authority since, as the Committee acknowledged, the authority of its standards rested on their general acceptability.36
In an attempt to address some of these shortcomings, the AICPA, successor to the AIA, reorganized its standard setting activities in 1959. As reconstituted, the AICPA established the APB to replace the Committee and gave the APB the authority to issue accounting standards. Additionally, the AICPA had a vision that the APB would develop a definitive statement of accounting principles upon which subsequent standard setting could be based. In particular, the AICPA's Special Committee on Research Program envisaged a hierarchy of postulates, principles, and rules to guide the APB's work:
The broad problem of financial accounting should be visualized as requiring attention at four levels: first, postulates; second, principles; third, rules or other guides for the application of principles in specific situations; and fourth, research.
Postulates are few in number and are the basic assumptions on which principles rest. They necessarily are derived from the economic and political environment and from the modes of thought and customs of all segments of the business community. The profession should make clear its understanding and interpretation of what they are, to provide a meaningful foundation for the formulation of principles and the development of rules or other guides for the application of principles in specific situations.37
The APB began an effort to establish a set of postulates and principles upon which standards could be based. Unfortunately, the APB was unsuccessful in doing so38 and, thus, its standard setting efforts were similar to its predecessor. Not surprisingly, the APB suffered from many of the same criticisms as had been leveled against the Committee on Accounting Procedure.
In 1973, a new organization independent of the AICPA, the Financial Accounting Foundation ("FAF"), was created to oversee the standard setting process. The body created under the FAF to carry out that standard setting activity was the Financial Accounting Standards Board. In an attempt to more clearly define the authority of the FASB for establishing accounting standards for use in financial statements filed with the Commission, the Commission issued the following statement:
Various Acts of Congress administered by the Securities and Exchange Commission clearly state the authority of the Commission to prescribe the methods to be followed in the preparation of accounts and the form and content of financial statements to be filed under the Acts and the responsibility to assure that investors are furnished with information necessary for informed investment decisions. In meeting this statutory responsibility effectively, in recognition of the expertise, energy, and resources of the accounting profession, and without abdicating its responsibilities, the Commission has historically looked to the standard-setting bodies designated by the profession to provide leadership in establishing and improving the accounting principles. The determinations by these bodies have been regarded by the Commission, with minor exceptions, as being responsive to the needs of investors.
The body presently designated by the Council of the AICPA to establish accounting principles is the FASB. . . .
In ASR 4, the Commission stated its policy that financial statements prepared in accordance with accounting practices for which there was no substantial authoritative support were presumed to be misleading and that footnote or other disclosure would not avoid this presumption. . . . For purposes of this policy, principles, standards, and practices promulgated by the FASB in its Statements and Interpretations will be considered by the Commission as having substantial authoritative support and those contrary to such FASB promulgations will be considered to have no such support.39
Armed with that statement of support, the FASB embarked on its standard-setting activities.40 In so doing, the FASB's initial efforts were directed along two different tracks. On the one hand, the FASB issued standards addressing specific transactions and events. Additionally, the FASB undertook a major effort to establish a conceptual framework of financial reporting.
The results of the deliberations on the conceptual framework by the FASB are found in its Statements of Financial Accounting Concepts ("Concepts Statements").41 The FASB noted that the primary purpose of the conceptual framework is "to establish the objectives and concepts that the [FASB] will use in developing standards of financial accounting and reporting."42
ii. Current Role of Conceptual Framework in Standard Setting
The FASB issued its Concepts Statements in large part to provide it with a framework for developing its subsequent standards. To be sure, to the extent that the FASB does develop standards based on its conceptual framework, it achieves some measure of success in having standards that are principles-based.43 In an effort to demonstrate that its standards are, indeed, grounded in its conceptual framework, the FASB has begun to include in its standards a discussion of how the standard relates to and is based upon the conceptual framework.44
It is important that the FASB issue standards that are based on its conceptual framework. However, as currently constructed, the conceptual framework does not always provide a complete roadmap to guide the standard setters to that optimal point on the continuum.45 Thus, not surprisingly, an examination of the current body of literature reveals that there are standards that are relatively principles-based while there are other standards that are more rules-based. Further complicating the standard setters' efforts to issue standards at the optimum point on the continuum is that there have been multiple standard setting bodies.
iii. Current Role of AcSEC, the EITF, and the FASB Staff46
The current GAAP hierarchy identifies several different bodies with the ability to issue authoritative accounting standards.47 In addition to the FASB, the AICPA's Accounting Standards Executive Committee ("AcSEC"), the Emerging Issues Task Force ("EITF"),48 and the FASB staff have the ability to issue standards that are included within the body of literature designated as authoritative.
AcSEC currently has the ability to issue Statements of Position ("SOPs"), Industry Audit and Accounting Guides, and Practice Bulletins,49 all of which are included within the GAAP hierarchy.50 Many of these documents focus on specific industry issues. The proliferation of "specialized industry standards" creates two problems that can hinder standard setters' efforts to issue subsequent standards using a more objectives-oriented regime:
Consensus positions reached by the EITF constitute authoritative guidance. The EITF was formed in 1984 in response to the recommendations of the FASB's task force on timely financial reporting guidance and an FASB Invitation to Comment on those recommendations. Members of the EITF are drawn primarily from public accounting firms but also include representatives of industry nominated by the Financial Executives Institute, the Institute of Management Accountants, the Business Roundtable, and, most recently, the user community. In an effort to achieve the goal of providing timely guidance, the EITF has considered in excess of 20 issues per year, on average. Thus, the activities of the EITF, while often timely and valuable, have contributed to a proliferation of standards often containing very detailed guidance.
Lastly, the staff of the standard setter has the ability to provide formalized guidance on the application of existing standards.51 Historically, the FASB staff has addressed these questions either through staff announcements52 or through the issuance of Q&As.53
Under the securities laws, including the Act, the Commission has the responsibility to develop accounting standards to be used by public companies. Despite the fact that it has consistently looked to the private sector for assistance in this task, the SEC retains the authority to establish standards if it so chooses. The SEC's authority would allow it to overturn an FASB standard by passing a Commission rule. This authority has rarely been used.
i. Examples of Rules-Based Standards
An examination of the U.S. literature reveals that there are certain standards (and related interpretive guidance) that are rules-based. In particular, there are four topics for which the bodies of literature are often thought of as being overly rules-based. These are: accounting for leases, accounting for derivatives and hedging activities, stock-based compensation arrangements, and derecognition of financial assets and liabilities.54 As we have noted previously, the primary characteristics of rules-based standards are the existence of exceptions and bright-lines which lead to very detailed implementation guidance, which often leads to even more bright-lines.55
Consider these bodies of literature in that context. Paragraphs 10-11 of SFAS No. 133 list nine exceptions to its scope. In part, the demand for increased implementation guidance was created by the scope exceptions. Currently, there are 15 Derivative Implementation Group ("DIG") issues related to the application of those scope exceptions.56 Of course, the detailed implementation guidance on derivatives does not stop with the question of scope. In total, there are over 800 pages of guidance on accounting for derivatives.57
The lease accounting literature provides another example of a rules-based standard. The lease literature is composed of 16 FASB Statements and Interpretations, nine Technical Bulletins, and more than 30 EITF Issues. Additionally, the fundamental standards for classifying a lease as capital vs. operating are predicated on the use of bright-lines (e.g., in classifying a lease as a capital lease it must meet one of four tests; two of which contain strict percentage thresholds (75% and 90%)).
The literature on stock-based compensation allows for either a fair value or an intrinsic value approach to accounting for employee stock-based compensation. Additionally, within the intrinsic value model, there is a sharply different accounting answer if the arrangement is a fixed award vs. a variable award. This distinction has fueled the demand for increased guidance.58
Likewise, the literature on derecognition of financial assets and liabilities has been criticized as overly rules-based. In addition to the guidance found in SFAS No. 140,59 the FASB issued a Technical Bulletin to clarify certain aspects of SFAS No. 140. Also, the FASB staff issued a Q&A containing 123 paragraphs plus tentative guidance on qualifying SPEs containing six additional questions and answers.
Other standards contain many of these same shortcomings. For example, bright-lines are stated (or implied)60 in standards such as:
Additionally, detailed implementation guidance has been provided by the FASB staff on issues such as:65
While other examples could be provided, it is clear that portions of the U.S. authoritative literature are located towards the overly-specific end of the spectrum, past the optimal point.
ii. Examples of Principles-Based Standards
Having noted that there are a number of extant standards that are more rules-based, it also is fair to say that some standards are closer to a principles-based regime. (Note that we are using the term principles-based here to describe standards that approach the ideal variant we have labeled objectives-oriented.) Beginning with the issuance of SFAS No. 141, the FASB has included in its standards a discussion of how the standards improve financial reporting and how the conclusions in the standard relate to the conceptual framework. Not surprisingly, then, we find that SFAS Nos. 141 and 14268 are examples of standards that are principles-based. Indeed, while the standards do not take on the exact format that we describe later, they do contain most of the fundamental elements of objectives-oriented standards. In particular:
Other recently issued standards comply with aspects of the objectives-oriented approach as well. Examples include SFAS Nos. 143 (asset retirement obligations), 144 (impairment of long-lived assets) and 146 (liabilities for existing activities). Furthermore, some of the older standards can be described as relatively principles-based as well. Examples include ARB No. 43, Chapter 4 (accounting for inventory), SFAS Nos. 34 (interest capitalization) and 52 (foreign currency translation).
iii. Examples of Principles-Only Standards
Even as there are and have been some standards that are rules-based, there also are and have been some that are principles-only. As we noted previously, standards that are principles-only typically do not provide sufficient framework for the application of judgment. Examples of principles-only standards are:
As these examples demonstrate, principles-only standards establish the basic principle but may not provide sufficient guidance for implementation. The outcome can be a loss of comparability.
The FASB's conceptual framework is predicated on the fundamental notion that the information provided through financial reporting should be useful to investors in making investment decisions.69 In its standard setting activities, the FASB must make determinations about appropriate accounting in light of this decision-usefulness criterion.
The FASB also must establish standards consistent with the qualitative characteristics of accounting information as defined in Statement of Financial Accounting Concepts ("SFAC") No. 2. In SFAC No. 2, the FASB established relevance and reliability as the primary decision-specific qualitative characteristics and comparability as a secondary qualitative characteristic.70 The challenge for the standard setters, of course, is not in coming to an agreement that accounting information should be relevant, reliable, and comparable. Rather, the challenge is in making the trade-off among these three characteristics. SFAC No. 2 discusses the issue of trade-offs as follows:
Although financial information must be both relevant and reliable to be useful, information may possess both characteristics to varying degrees. It may be possible to trade relevance for reliability or vice versa, though not to the point of dispensing with one of them altogether. Information may also have other characteristics . . . to varying degrees, and other trade-offs between characteristics may be necessary or beneficial.71
Thus, a key responsibility of the standard setters is to make the determination as to the trade-offs among the qualitative characteristics of accounting information to ensure that the information portrayed in the financial statements is representationally faithful to the underlying substance of the transaction or event and can be portrayed to investors in a manner that is understandable to them. In practice, making these trade-offs in setting standards is closely intertwined with the problem of defining the scope of a standard and, more fundamentally, with the use of the asset/liability view to standard setting.
Before discussing specific implementation issues associated with the adoption of a more objectives-oriented regime in the U.S., it is necessary to examine an even more fundamental aspect of standard setting regarding the definition and classification of the basic elements of accounting. The question is: what are the fundamental building blocks of accounting standards? Broadly speaking, there are two basic approaches to definitional issues that standard setters can use in establishing standards: (a) the asset/liability view or (b) the revenue/expense view.
In the asset/liability view, the standard setter, in establishing the accounting standard for a class of transactions would, first, attempt to define and specify the measurement for the assets and liabilities that arise from a class of transactions. The determination of income would then be based on changes in the assets and liabilities so defined.72 Thus, in this view, the accounting for transactions and events involves identifying assets and liabilities, and changes in those assets and liabilities, associated with the underlying transactions and events.73
Conversely, the revenue/expense view would call upon the standard setter to establish standards that give primacy to the direct measurement and recognition of the revenues and expenses related to the class of transactions. Under this approach, the balance sheet becomes residual to the income statement, and contains assets, liabilities, and other accruals/deferrals74 needed to maintain a "balance sheet."75
From an economic perspective, it would seem that these two approaches should be the same since, from a conceptual perspective, revenues and expenses are simply incremental changes to assets and liabilities. Thus, whether revenues and expenses are defined in terms of assets and liabilities or vice versa, the results should be the same. From a practical accounting standard setting perspective, however, the selection of one starting point over the other is of considerable significance.
Under a revenue/expense view, scope tends to be defined either at too broad a level or at too narrow a level. To illustrate, consider the current literature applicable to revenue recognition. At one extreme, there is the very broad guidance: revenue should be recognized when it is earned and realized (or realizable).76 At the other end of the spectrum are an array of specific revenue recognition standards which address the accounting for narrowly-defined transactions or industries.77 Not surprisingly, an examination of these standards shows that various inconsistencies exist among the revenue recognition models.78
We believe that the revenue/expense view is inappropriate for use in standard setting-particularly in an objectives-oriented regime. In establishing an accounting standard, the standard setter is attempting to define and establish the accounting principles for the underlying economic substance of the class of transactions under consideration. As noted above, from an economic perspective, income represents a flow of, or change in, wealth during a period. Without first having an understanding of the wealth at the beginning of the period, it is not possible to determine the change in wealth during the period. The accounting equivalent to identifying "wealth" is identifying the assets and liabilities related to the class of transactions. This identification of wealth acts as a conceptual anchor to determining revenues and expenses that result from the flow of wealth during the period. Historical experience suggests that without this conceptual anchor the revenue/expense approach can become ad hoc and incoherent.
We see the optimal scope of a standard as being established by identifying assets or liabilities that, by virtue of their economic similarity, render a standard the most meaningful. Recognition and measurement questions should turn on that same economic underpinning.79 As noted above, historical experience suggests that the asset/liability approach most appropriately anchors the standard setting process by providing the strongest conceptual mapping to the underlying economic reality. Thus, we believe that this asset/liability foundation is crucial not only to the FASB's efforts to establish when identified assets and liabilities should be recognized and how they should be measured, but also to defining the optimal scope of a standard-that is, what transactions or events should be addressed by a standard.
We have posited that an objectives-oriented standard should have few, if any, scope exceptions.80 As previous discussion highlighted, one of the factors that creates increased complexity and a tendency towards a rules-based approach to standard setting is the existence of scope exceptions in a standard.81 To illustrate, consider SFAS No. 133. Paragraphs 10 and 11 contain nine different scope exceptions. In an effort to further clarify the application of some of those scope exceptions, the FASB has found it necessary to issue two amending documents-SFAS Nos. 138 and 149. Additionally, there are 15 DIG Issues related just to the issue of the scope of accounting for derivatives. Clearly, a consequence of scope exceptions is increased complexity and the need for more rules.
In reality, establishing the proper scope of the standard is one of the more difficult challenges. The scope of a standard could range from very broad to very narrow. If the scope is too broad, the standard setter would be unable to provide sufficient guidance for the standard to be meaningful and useful to preparers and auditors.82 This is apt to generate a proliferation of exceptions. However, if the scope of the standard is too narrow, it would not have sufficient applicability to justify the time and effort of the standard setter, and may not capture all transactions with similar economic substance.
How, then, is the standard setter to determine the optimal scope of a standard-the point at which the scope is sufficiently broad so as to be applicable to an appropriate group of economic transactions and events, but not so broad that numerous scope exceptions are needed? Clearly, a starting point to that process must be an understanding by the standard setter of the underlying economics of the transaction or event under study. Additionally, the standard setter must determine how that transaction or event affects the financial position of the company. From there, the standard setter can develop a standard that captures the underlying economics of the transaction or event, as defined by the standard setter, and specifies how and when the impact on financial position should be reported in earnings. Ultimately, it is the underlying economic substance that must drive the development of the scope of standards, if these standards are to remain stable and meaningful.
Thus, the standard setter must first be able to determine what assets and liabilities are created, eliminated, or changed by the transaction or event under consideration. As discussed previously, doing so necessitates that the standard setter adopt an asset/liability view when establishing accounting standards. It is the task of the standard setter to determine the appropriate trade-offs among relevance, reliability, and comparability within the context of the asset/liability view. Thus, in the final analysis, the theory of optimal scope is an effort to find the "sweet spot"83 on the continuum, which appropriately applies the asset/liability view, while selecting the proper trade-off among relevance, reliability and comparability.
When the standard setter succeeds in defining the optimal scope of a standard, it develops standards devoid of scope exceptions and bright-lines, and significantly increases the likelihood that the standard will result in accounting that is more representationally faithful in capturing the substance of the related class of transactions or events.84 Furthermore, it minimizes the opportunities for "gaming" the system by those who wish to engage in financial engineering.
The following section illustrates the theory of optimal scope by way of a standard setting example.
To illustrate this concept, consider the example of the FASB's standards on business combinations-SFAS No. 141.85 As we noted earlier, this standard is illustrative of standards which are near the optimum point on the continuum and, thus, can be described as objectives-oriented.86 In establishing a standard on business combinations, the FASB defined a business combination as follows:
A business combination occurs when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities.87
Included in this description are several important concepts which are critical to the conclusions in the standard. First, there is the notion that the entity must acquire control over another entity or business. Control brings with it the notion that the acquiring entity should consolidate its investment in the acquired business subsequent to the business combination.88 Thus, the FASB does not need to exclude the acquisition of investments accounted for by the equity method from the scope of the standard because, by definition, the acquisition of an equity method investee does not give rise to control. A similar decision was made by the APB when it addressed the issue of accounting for business combinations in Opinion No. 16.
Where the FASB and APB diverge, however, is in applying the concepts that are developed in articulating the scope to the establishment of the accounting standards. The FASB, by drawing upon the concepts that were developed in the articulation of the scope of the standard established a standard that is more representationally faithful to the underlying substance of the transactions-specifically, that in a business combination, one company acquires another. Thus, not surprisingly, SFAS No. 141 concludes that there is only one method to account for a business combination - the purchase method. APB Opinion No. 16 had specified that a business combination could be accounted for as either a purchase or a pooling of interests if the pooling criteria were met. Thus, APB Opinion No. 16 established an exception to its fundamental concept-that one company acquires another in a business combination.
The FASB, on the other hand, by establishing a clear definition of scope and applying an asset/liability view to the transactions included within that scope, established a standard without the need for numerous scope exceptions and bright-lines.89 The contrast between the rules-based approach used in APB Opinion No. 16 and a more principles-based approach used in SFAS No. 141 is illustrated in the following table.90
Comparison of Accounting Standard on Business Combinations Using Rules-Based (APB Opinion No. 16), Principles-Only, and Principles-Based (SFAS No. 141) Standard Setting
| Elements of Standard | Rules-Based (APB Opinion No. 16) | Principles-Based (SFAS No. 141) | Principles-Only |
| Basic principle: a business combination occurs when one entity obtains control over the operations of another entity or business | Yes-standard addresses accounting and reporting for business combinations | Yes-standard addresses accounting and reporting for business combinations | Yes-standard addresses accounting and reporting for business combinations |
| Objectives of standard clearly stated within the standard | No | Yes | No |
| Scope of standard clearly articulated | No | Yes | No |
| Sufficient guidance included in the standard | N/A | Yes | No |
| Numerous scope exceptions | Yes | No | No |
| Bright-lines | Yes-12 criteria for classifying combination as a pooling of interest | No-bright-lines eliminated; all combinations accounted for using the purchase method | No |
| Detailed implementation guidance included standard | Yes | No | No |
| Need for significant amount of subsequent guidance | Yes-Subsequent to the issuance of APB Opinion No. 16, additional detailed guidance was provided by, among others, the SEC staff through Staff Accounting Bulletins, the AICPA staff through AICPA interpretations, the EITF through numerous consensuses. | No | Not provided |
| Business combination defined | No | Yes | No |
| Comparability achieved | No-Because of the bright-line tests for determining whether a business combination was a pooling of interest, two combinations could be essentially the same economically, but have completely different accounting (see, Section I.G for a more complete discussion) | Yes | No-With the lack of sufficient structure and guidance in the standard, the resulting application of judgment would likely result in different accounting for similar transactions since there would be no framework for applying the needed judgment |
It is evident that there is a demand among accounting professionals for implementation guidance. This can be seen in the number of issues that are addressed each year by the EITF, the number of inquiries that the staffs of the FASB and SEC receive, and the volume of non-authoritative guidance that is published each year.91 The question is not whether such guidance will be provided, but when and by whom. Ultimately, under an objectives-oriented regime, there will still need to be guidance provided both at the time a standard is issued and subsequently.
Who has the responsibility for such guidance and its authoritativeness are key questions.92 (We further address this issue in Section IV.) We believe that the standard setter should make it clear that any implementation guidance included within a standard has the same level of authoritativeness93 as the standard itself since the standard setter is making a judgment contemporaneously with the development of the standard as to the amount of implementation guidance needed to operationalize the standard. Regarding the guidance itself, clearly, the standard setters should provide some implementation guidance as a part of a newly issued standard. We believe, however, that the amount of detail provided by the standard setter under an objectives-oriented regime would likely be less than that provided under a rules-based regime. Otherwise, the guidance would quickly transform what could be an objectives-oriented regime back into a rules-based regime, with all the consequent disadvantages discussed herein.
One of the potential challenges to transitioning from a rules-based to a principles-based regime is the question of how to deal with existing standards-particularly existing specialized industry standards-when the standard setter is in the process of developing a new or revised standard. One school of thought says that the standard setters should include "legacy" exceptions in its objectives-oriented standards. For example, a new standard might exempt insurance arrangements or investment companies or registered broker/dealers because there are specialized accounting standards applicable to those industries.
The danger in doing so is that, until those industry issues are addressed, comparability is hampered since companies in different industries with similar transactions may account for them differently. Furthermore, providing these legacy exceptions may create an incentive to avoid the application of the newer standard (e.g., a company could argue that it has an insurance product and, therefore, should be excluded from the scope of the standard under an exception for certain insurance products).
We recognize that transitioning from a rules-based to an objectives-oriented regime will take time and will involve delicate choices by the standard setters. We do not recommend a policy to either totally ban or to uniformly allow legacy exceptions. Rather, we believe that the standard setters should judiciously determine when it is appropriate to allow a legacy exception to its objectives-oriented standards. This will mean that the standard setters will need to weigh the costs resulting from the lack of comparability with the benefits of certain companies not having to undergo the change in accounting policy.
Some have suggested that a necessary component of principles-based standards is the inclusion of a "true and fair override."94 A true and fair override would permit a company to depart from accounting principles established by the standard setter (thus "overriding" those standards) if the override results in a "true and fair" presentation of the company's financial position, results of operations and cash flows.95
While we believe that it is important for preparers and auditors to determine that the financial statements clearly and transparently provide information to investors that allows them to evaluate the company's financial position, results of operations, and cash flows, we do not believe that a "true and fair override" is a necessary component of a principles-based or objectives-oriented standard setting system. In fact, we would expect that an objectives-oriented standard setting regime should reduce legitimate concerns about the established standards not providing appropriate guidance, as the standards should be based on objectives that would almost certainly not be met by a presentation that was not "true and fair".
While this view might seem, on the surface, to be inflexible, it is, in fact, grounded in the objectives-oriented standard setting model. There are various ways that the economics of an arrangement can be viewed and evaluated. Reasonable people can reasonably disagree on the economics of an arrangement. It is, however, precisely the role of the standard setter to define the class of transactions included within the economic arrangement and to then establish the appropriate accounting for that class of transactions. While not everyone will agree with the standard setter's conclusions, making the determination of the underlying economics of an arrangement and the appropriate accounting for that arrangement are integral to the standard setter's role. Thus, we believe that when the standard setter establishes standards under an objectives-oriented regime, the accounting should, in virtually all cases, be consistent with the standard setter's view of the nature of the economic arrangement.
To this point, we have discussed the key characteristics of accounting standards that are developed under an objectives-oriented regime. The determination of exact format of a standard (whether objectives-oriented or rules-based) is, ultimately, the responsibility of the standard setter. However, we believe that an objectives-oriented standard should contain the following elements:
As the analysis in this study indicates, we believe that a continuing shift to an objectives-oriented regime could result in a net benefit to the FASB's constituents. It would result in standards that are more consistent with the FASB's conceptual framework. As we demonstrate in Section V, this should, in turn, result in accounting information that is more decision-useful to investors. This will necessitate a change in behavior, however, not just by the standard setters, but also by preparers, auditors, and investors.
i. Exercise of Professional Judgment
One consequence of continuing to move to an objectives-oriented regime is that preparers and auditors would be called upon to exercise professional judgment in a different way than is currently required.97 There are at least two identifiable consequences to this.
First, there is the short-run consequence. Preparers would need to resist the temptation to challenge auditors by demanding written guidance in order to accept an auditor's judgments.98 Additionally, preparers could not rely on financial engineering of structures to achieve a desired accounting result.99 As a corollary to that, auditors would need to be weaned away from the check-list mentality. Since auditors would need to make sure that the accounting is consistent with the objective, rather than that it meets a specific set of rules, auditors will, in some cases, be faced with the prospect of having the rules-based security blanket removed.100
Second, there is the long-run consequence. Since the application of an objectives-oriented regime relies on preparers and auditors' ability to identify the objectives of the standard (as well as the specific guidance) and match that to the underlying transaction or event, there is a need to train preparers and auditors in understanding the substance of the class of transactions. Additionally, it appears likely that in moving to a more objectives-oriented regime, the FASB will issue more standards that rely on fair value as the measurement attribute. If so, it would be imperative that accounting professionals be trained in valuation theory and techniques.
ii. More Transparent Disclosure
As we demonstrate in Section V, under an objectives-oriented regime, there is a greater incentive for management to "tell its story." We posit that an objectives-oriented regime creates an incentive for good companies to be more forthcoming in providing clear and transparent information to investors.101 Doing so should, in turn, result in information that is more understandable (and, hence, more useful) to investors.102
Furthermore, under an objectives-oriented regime, users have a greater incentive to participate in the standard setting process. Since, under an objectives-oriented regime, the discussion is not focused so much on intricate details surrounding the application of the standard, users should have a greater ability to engage in the process. The barrier to entry into this discussion is therefore lowered. Thus, if the standard setting body is able to reach out to key user stakeholders to engage them in the process, there is a greater likelihood that standards would be issued which result in accounting information that is more meaningful to users.103 And, as preparers are incented to get their story out to investors in a manner that reflects the economic substance of the company's financial position and results of operations, preparers should be willing to provide more transparent disclosure. This, in turn, should provide an incentive to users both to study the information with greater diligence and to participate more actively in the standard setting process.
An objectives-oriented regime should create incentives for companies with "good stories to tell" to do so in a clear and transparent manner. However, another question remains: under an objectives-oriented regime, what is to prevent those who do not have a good story to tell from fabricating a good story? In reality, there are two primary gate-keepers. The first gate-keepers are the independent auditor and the company's audit committee.105 As we noted earlier, the reforms contemplated by the Act require changes in behavior for the auditor and greater vigilance by the audit committee.106 Indeed, the Commission has demonstrated a willingness to hold auditors accountable when they fail to uphold their gate-keeping role.107 Thus, the recent strengthening of both the role of the audit committee and the auditor independence rules by the Act and the Commission's related rule-making are important components in making objectives-oriented standards effective.
That, of course, leads us to the second gate-keeper-the enforcement bodies. It has been argued that a principles-based regime in place in the U.K was not successful until coupled with an effective enforcement mechanism.108 Research also has shown that strong enforcement coupled with flexibility in reporting can be advantageous to investors.109 We provide further support for this proposition in Section V.
We believe that the existence of a strong and consistently applied enforcement mechanism is a necessary component to the success of an objectives-oriented system. Preparers and auditors have expressed concern that those charged with enforcement in a principles-based environment will question reasonable judgments made in good faith.110 In fact, some have asked whether the Commission staff would be willing to accept reasonable views and interpretations by preparers and auditors in the application of accounting principles.111
In the event that a preparer's or auditor's accounting is questioned in an enforcement investigation under an objectives-oriented regime, the issue ultimately should be whether the judgments made were supported based on the facts and circumstances available at that time, just as it is now. Thus, it would seem prudent for preparers and auditors not only to make appropriate judgments on the application of the standards to their facts and circumstances, but also to document, on a contemporaneous basis, those facts and circumstances, what alternative accounting treatments were considered, which was accepted, and why that application was accepted and the others rejected. Further, as required by the Commission's rules, auditors should communicate alternative applications of GAAP that have been discussed with management to the company's audit committee.112
Given the need for a strong enforcement mechanism in order for an objectives-oriented regime to function properly, the key point for preparers and auditors is that they be able to demonstrate that they have made reasonable, good faith judgments and interpretations of the applicable accounting literature in accounting for transactions and events which affect the company's financial position, results of operations, and cash flows. Nonetheless, given the environment in which U.S. preparers and auditors function, there is a legitimate concern that evaluations about appropriateness of a company's accounting are made in light of hindsight. As such, there is a premium for preparers and auditors to demonstrate that they made reasonable, good-faith judgments at the time in accounting for transactions and events.
To reiterate the point made above, this can best be demonstrated by:
Having established the basis for the objectives-oriented regime and the necessary components, we turn our attention to the specific steps that must be taken to continue the process of implementing a more objectives-oriented regime in the U.S. We anticipate that the change should occur over time as the FASB examines specific topics in the course of carrying out its standard setting process.
As we discussed earlier in this study, the FASB has begun to use a more objectives-oriented form in issuing its standards. Additionally, a comprehensive review of the existing body of authoritative literature is underway to serve as a basis for agenda decisions and prioritizing agenda items. Additional key steps needed to implement an objectives-oriented regime in the U.S. standard-setting process include:114
As noted previously, the FASB uses its conceptual framework in the process of developing accounting standards. Accordingly, having a clear, consistent conceptual framework is a necessary step in facilitating a move towards a more objectives-oriented regime. There appears to be general agreement that there is a need for the FASB to undertake a "conceptual framework improvements" project115 as part of such a shift.116 At issue is what the focus of this effort should be.
As the FASB's proposal acknowledges, there are, arguably, several facets of the conceptual framework which need to be addressed to facilitate the shift to a more principles-based regime. We believe that there are three key issues which the FASB should address relative to its conceptual framework as steps integral to continuing its move to an objectives-oriented regime. We see this as a "three-legged stool" involving the following efforts:
As observed previously, the FASB's conceptual framework currently contains an acknowledgment of the need to make trade-offs among the qualitative characteristics of relevance, reliability, and comparability. Unfortunately, as currently constructed, the framework does not provide a useful structure or guide as to how these trade-offs should be made. We recognize that the determination of the proper trade-off is a key part of the Board's responsibility in establishing accounting standards. If the basis for making the trade-off were more clearly articulated, it would provide both the Board and the profession with a clearer roadmap to understand the spirit as well as the letter of a new standard. Doing so would necessitate a change, primarily to SFAC No. 2.
The asset/liability view is fundamental to the FASB's ability to draw upon the conceptual framework in its standard setting efforts. Unfortunately, the asset/liability view and the historical notion of an "earnings process" for recognition of revenue are not completely consistent.117 Since we believe that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented standard setting regime, we also believe that the FASB should eliminate the inconsistency by removing the need to assess the earnings process in the determination of revenue recognition. Doing so would likely involve a change primarily to SFAC No. 5. We recognize that this also may mean that the FASB will need to clarify some aspects of its definitions of the elements of financial statements resulting in a modification to SFAC No. 6.
The third major leg of the stool is the need to provide guidance on the determination of the appropriate measurement attribute. As the FASB and others acknowledge, financial reporting currently is based on a "mixed attribute" model.118 In some instances, historical cost (or amortized cost) is used. In other instances, fair value is used. In other instances, lower of cost or market is used. Beyond that, of course, is the added confusion about when adjustments to carrying amounts are recognized in earnings. We believe that the FASB's continuing shift to an objectives-oriented regime should be greatly enhanced by an articulation of "concepts" for the use of various measurement attributes since measurement is a key element of any accounting standard.119 Doing so would necessitate significant modifications to SFAC No. 5 and, possibly, SFAC No. 7 as well.
We believe that many projects currently on the FASB's agenda can form the basis for much of the work that should be done on the conceptual framework. For example, the FASB's revenue recognition project could form the basis for eliminating the inconsistencies between SFAC Nos. 5 and 6 on revenue recognition.120 Likewise, the current project on liabilities and equity will address some of the questions about definitions of elements of the financial statements such that work on this project could form much of the basis for needed clarification to the definition of the elements.121 Finally, the current projects on measuring financial instruments at fair value, measurement, and financial performance could serve as the basis for needed clarity as to the application of appropriate measurement attributes.122
As discussed earlier, 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.123 Both the FASB and the IASB have stated an intention to seek greater convergence of U.S. and international accounting standards. Furthermore, the SEC has endorsed this initiative.124 In working towards convergence, the Boards have established a "short-term" working plan and a long-term plan. In its short-term working plan, the Boards have identified topics where convergence issues might be addressed quickly. For some of these matters, the FASB has been charged with the "lead" responsibility in developing or achieving a converged, high-quality solution; whereas for other items, it is the IASB that is charged with that responsibility.125 The two Boards have targeted December 31, 2003 to achieve most, if not all, of the items on the short-term convergence list.126
Additionally, the two Boards have a long-term convergence strategy which will involve joint efforts on many of the Boards' current agenda projects127 as well as an international convergence research project whereby the FASB staff can:
We believe that a continuing shift by the FASB towards a more objectives-oriented regime should facilitate the convergence process.129 Since the convergence project will require both Boards to seek a high-quality solution to the accounting issues addressed within an objectives-oriented regime, we believe that much of the transition towards a more objectives-oriented regime could occur along with convergence efforts. In light of the 2005 deadline created by the impending adoption of IFRS within the European Community,130 we expect that the Boards will work most intensely through 2004 and, possibly, into 2005 in an effort to achieve a significantly improved degree of convergence.
As item (3) above indicates, the determination of the Boards' respective agendas will be a part of this process. This will include prioritizing agenda items as well as adding new items to the agenda. As the standard setters move forward, the decisions of what items to add to the agenda and their relative priority will be of crucial importance in setting the pace for a shift to a more objectives-oriented regime.131
The third step in the process of implementing a more objectives-oriented regime in U.S. financial reporting is a realignment of the GAAP hierarchy. The current GAAP hierarchy is organized as follows:132
Authoritative literature:
Level A - FASB's Statements of Financial Accounting Standards and Interpretations, APB Opinions, and ARBs
Level B - FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides and Statements of Position
Level C - EITF Consensuses and AICPA Practice Bulletins
Level D - AICPA accounting interpretations, FASB staff Q&As, and industry practice
Other literature:
SFACs, AICPA Issues Papers, IASs, textbooks, articles in professional journals.
As is evident from reviewing the existing GAAP hierarchy, industry practice is placed above the FASB's conceptual framework. The reason for this, of course, is that the conceptual framework, as currently constructed, is intended primarily to aid the FASB in its deliberations.133 However, when the FASB completes its efforts to improve the conceptual framework, that body of literature should serve not only as a guide for the FASB in its subsequent deliberations, but also as a guide for accounting professionals as they attempt to resolve difficult issues in practice for which there is not clear guidance in the literature. The direct use of the conceptual framework by preparers and auditors to complement standards should permit standard setters to draft more succinct standards than they otherwise could.
Because of that, we would envision a change in the GAAP hierarchy at that point such that it appeared more along the lines of the following:
Authoritative literature:134
Non-authoritative literature:
Clearly, such a change would dramatically alter the current professional thinking about the importance of the conceptual framework relative to other documents in the literature. Furthermore, it would, no doubt, require a change in the educational focus of the accounting profession (both at academic institutions and in professional organizations and other continuing professional education activities). Such a shift in the hierarchy, however, would be a necessary part of the shift in behavior (described earlier) which is needed among preparers and auditors to aid the FASB's shift to a more objectives-oriented regime.
One of the key issues to be addressed in an objectives-oriented regime is who should provide implementation guidance subsequent to the issuance of a standard. As is the case currently, there will inevitably be questions that arise as accounting professionals attempt to apply the standards to specific fact patterns. This guidance will likely be developed in two different, yet important ways: (1) formal guidance and (2) informal guidance. This distinction is important, not only in characterizing the way the guidance is likely to be developed, but also in characterizing its authoritativeness.135
Consistent with our previous discussion on a revised GAAP hierarchy, we believe that there will continue to be a need for a "body of experts" to address and resolve certain implementation questions. In the U.S., that body has, since 1984, been the EITF. We believe that such a body should continue to function to address certain implementation questions that arise.136 However, the manner in which it functions and the number of issues that it undertakes should be carefully examined.
Since it