Principles-based accounting standards - Essay Example

Principles-based accounting standards. INTRODUCTION Some recent discussions of U.S. financial reporting include implicit or explicit recommendations that the U.S. abandon the current allegedly "rules-based" system in favor of a "principles-based" system, with the implication that some or all of the current difficulties facing U.S. financial reporting would be alleviated or even eliminated by such a shift. (1) In addition, Section 108 of the Sarbanes-Oxley Act of 2002 instructs the Securities and Exchange Commission (SEC) to conduct a study on the adoption of a principles-based accounting system.

The study is to have four elements: * The extent to which a principles-based accounting system exists in the U.S.; * The time required to change to such a system; * The feasibility of such a system (and how it might be implemented); and * An economic analysis of the implementation of a principles-based system. Two themes emerge from these discussions. The first theme is that the current financial reporting system in the U.S. is undesirable or inappropriate because it is rules-based, fostering an alleged current "check-box" or compliance mentality that is, in the view of some, an open invitation to financial structuring and other activities that subvert high-quality financial reporting.

The second theme is that moving to a principles-based system is desirable, because such a system allows (or requires) the appropriate exercise of professional judgment. As part of these discussions, the Financial Accounting Standards Board (FASB) developed a "Proposal for a Principles-Based Approach to U.S. Standard Setting," available at http://www.fasb.org, and has held a public roundtable discussion. Relative to this commentary, the perspective of the FASB's proposal is that of standard setting, while I take a combined standard-setting and accounting-research perspective.

In addition, the FASB's proposal considers several matters that I do not discuss, such as the possibility of a "true and fair override," and changes to the roles, composition, and processes of other standard setters such as the Emerging Issues Task Force. This commentary is intended to raise several empirical questions that might be asked in discussions about the attributes, desirability, and effects of "principle-based accounting standards." I begin with an argument that U.S. GAAP is based on a recognizable set of principles derived from the FASB's Conceptual Framework, but nonetheless contains elements that cause some commentators to conclude that U.S. accounting is "rules-based.

" I discuss these "rules-based" elements and raise questions about how they affect the comparability, relevance, and reliability of reported numbers. I also consider the potential attributes of "principle-based standards" and, given the specifics of the current reporting system, some potential consequences if U.S. financial reporting standards were to shift so as to exhibit those attributes. IS U.S. FINANCIAL REPORTING BASED ON PRINCIPLES The FASB's standard-setting activities are guided by its Conceptual Framework, as laid out in its Concepts Statements. (2) One important source of guidance is the definitions of financial statement elements in Concepts Statement No. 6. Only items that meet the definition of an element, such as asset, liability, revenue, and expense, are to be reported, and as an additional source of standard-setting discipline, the income statement elements are defined in terms of the balance sheet elements. (3) I note that, from a standard-setting perspective, it is taken for granted that an item that meets the definition of a financial reporting element is relevant to investors.

Recognition and measurement requirements of accounting standards are to be based on the qualitative characteristics of accounting information laid out in Concepts Statement No. 2. The overarching concept is decision usefulness, supported by relevance, reliability, and comparability. (4) I interpret these concepts as follows. The desire to achieve comparability and its over-time counterpart, consistency, is the reason to have reporting standards. That is, if similar things are accounted for the same way, either across firms or overtime, it becomes possible to assess financial reports of different entities, or the same entity at different points in time, so as to discern the underlying economic events.

If little value is attached to having the same accounting treatment applied to identified classes of similar items, then preparers of financial reports could reasonably be left to choose the reporting that best suited their own communication strategies. (5) Once it is agreed that comparability is desirable, relev ance and reliability assist in deciding which standards to have--that is, what the requirements for recognition, measurement, and disclosure should be. To the extent U.S. GAAP is aimed at providing comparable, relevant, and reliable financial reporting, it is principles-based.

Finally, the Conceptual Framework contains criteria for recognition and measurement in Concepts Statement No. 5. However, much of this Statement "merely describes [what was then] current practice and some of the reasons that have been used to support or explain it but provides little or no conceptual basis for analyzing and attempting to resolve.. .issues of recognition and measurement.." (Storey and Storey 1998, 158.) That is, Concepts Statement No. 5 has not proved to be useful in resolving key standard-setting issues.

Some of the standard-setting difficulties in resolving recognition and measurement issues would be eliminated or at least mitigated if Concepts Statement No. 5 were thoroughly overhauled. Some of the Concepts Statement No. 5 recognition principles--the descriptions of what was then current practice--conflict with the elements definitions in Concepts Statement No. 6. For example, the application of the "completion of the earnings process" criterion for revenue recognition from Concepts Statement No.

5 sometimes causes the recording of deferred revenues that are not liabilities. In addition, the use of "earnings process" as a standard-setting concept implies that each distinct earnings process might have its own revenue recognition standard, causing the volume of accounting guidance for revenue recognition to grow almost without limit as new business models, with their attendant earnings processes, are created. One goal of the FASB's.