In late July 2003, the Securities and Exchange Commission (SEC) released a staff study required by Section 108(d) of the Sarbanes-Oxley Act. The study strongly recommends that accounting standards be developed using a principles-based approach. In several prior articles, we encouraged this change. Although the full impact will take years to occur, the overall result should be profound.
What is the Change?
Over the years, accounting rule makers have moved towards pronouncements that are more detailed and precise. While this may at first sound appealing, the additional detail often took the form of safe harbor rules and related mathematical tests to determine how a particular transaction was recorded. Public accountants/auditors generally liked this additional detail because (i) it provided a clear-cut explanation to clients as to why a proposed transaction should be handled in a particular fashion, and (ii) as long as the rules were followed, it was believed that the accounting firm would not be sued.
The problem is that overly detailed rules foster a creative attitude of reverse engineering and manipulation. When the mechanical rules are followed, then the accounting is deemed proper. Enron is a good example. Few people will argue that Enron’s accounting made much sense. But with the exception of a limited number of relatively minor items, no one has said that Enron’s accounting broke the precise and technical accounting rules.
The SEC’s report recommends that standards be developed that have the following characteristics:
- Are based on an improved conceptual framework that is more consistently applied;
- Clearly state the objective of the standard;
- Minimize exceptions from each standard, and
- Avoid use of percentage test or “bright lines” that allow financial engineers to achieve technical compliance with the standard, while evading the standard’s objective.
The SEC study provides specific examples of existing accounting standards that are principles based, and other standards that are rule based. The following rule based standards will likely be changed:
- Derivatives and hedges (read Enron)
- De-recognition of financial assets and liabilities (read Enron again)
- Stock-based compensation arrangements
The report commented on the role of the Emerging Issues Task Force (EITF). The EITF has been the U.S. authority on accounting implementation issues that arise on a more short-term basis. Since its inception in 1984, the EITF has examined 424 issues, or approximately 24 per year. Many have commented that this volume of EITF work is the result of accounting pronouncements being too rules-based, which then requires “finger-in-the-dike” answers when creative persons identify loopholes in the accounting pronouncements. The SEC wants the EITF’s role decreased, and believes that this change can occur if the rules are principles-based. Restrictions are occurring in the EITF’s authority and membership, which will tend to slow down the volume of EITF pronouncements. However, if the proposed changes do not yield the desired results, then the EITF may not be able to provide necessary guidance to prevent accounting creativity.
The SEC report reaffirms the role of the Financial Accounting Standards Board (FASB) as the primary accounting rule making body. While this may seem routine, consider that the rule-setter for auditing standards (the Auditing Standards Board of the American Institute of Certified Public Accountants) recently lost its job. Should the FASB not address the specific concerns expressed in the SEC report, the FASB will also find itself out of a job. In connection with the release of the SEC report, SEC Chairman Donaldson softly threatened the FASB by saying that the SEC
“will continue to monitor the FASB’s procedures, qualifications, capabilities, activities, and the results of its standard setting activities. The approach to establishing accounting standards is an important part of our evaluation of the FASB’s activities. I want to commend the staffs of the Office of the Chief Accountant and the Office of Economic Analysis for their thoughtful study, which endorses an approach to setting accounting standards that should result in investors receiving more transparent information about a company’s financial results and position.”
What is the Impact on Lawyers?
One of the costs of replacing bright lines with gray judgments is increased litigation risk for the companies that issue financial statements, and their outside accountants. With the benefit of 20/20 hindsight, some judgments will inevitably look wrong. When this happens, there will no longer be firm rules to prove that the judgments were correct. Whether in addressing issues beforehand or picking up the pieces afterwards, lawyers will need to be aware of the subtle but important change in the accounting rules.
The SEC acknowledged that the lack of objective rules could be a problem. According to the report:
“It is possible that objectives-oriented accounting standards could increase the vulnerability of accounting firms to “strike” suits by plaintiff’s attorneys. That is, by requiring a different application of judgment, objectives-oriented accounting standards also could generate greater uncertainty in the outcome of any given plaintiff’s case. This increased uncertainty and expected expense may result in higher settlements for suits brought by the plaintiff’s bar, some of which constitute mere nuisance suits.”
The same will be true for the companies whose financial statements are in question.
Clients previously wanting a particular accounting result needed to have the underlying contracts follow the precise accounting rules. This caused interaction between the accountants and lawyers in order to meet the client’s objectives. There will still be interaction between the accounting and legal professionals, but the conversations are less likely to center on mechanical applications of detailed rules.