The Sensibility of Principles-Based Accounting Standards: Financial Accounting Would Be More Accurate If There Were Fewer Rules-Including Fewer Rules for Valuing Stock Options

By Mano, Ronald M.; Mouritsen, Matthew L. | Strategic Finance, May 2004 | Go to article overview

The Sensibility of Principles-Based Accounting Standards: Financial Accounting Would Be More Accurate If There Were Fewer Rules-Including Fewer Rules for Valuing Stock Options


Mano, Ronald M., Mouritsen, Matthew L., Strategic Finance


The Financial Accounting Standards Board (FASB) had been trying to resolve the issues about measuring the expense of stock options long before it published its Proposed Statement of Financial Accounting Standards, "Share-Based Payment," in March. But instead of wrangling over valuation details, we believe the Board should avoid this type of rules-based accounting. Instead, it should issue a principle of accounting for stock options and let the accountants deal with the specifics of how to measure the size of the expense. For that matter, the FASB shouldn't issue rules at all--only principles.

MIND OVER MATTER

Nowhere have we seen the idea of rules- vs. principles-based accounting articulated better than in an ad from PricewaterhouseCoopers circa April 2003. So let's begin by quoting the ad verbatim:

OUR OBSERVATIONS

We applaud PricewaterhouseCoopers for taking this bold stand in favor of principles-based accounting standards.

Another pithy way of making this point came in 1972 from now-retired professor Robert R. Sterling of Rice University, the University of Kansas, and the University of Utah: "It is much easier and more diplomatic to accuse someone of breaking a rule than to accuse him of telling a lie."

Herein lies the problem that we external accountants have created: We haven't been willing to accuse our clients of telling a lie. We've allowed any sort of accounting the client was willing to promote unless there was a rule saying we couldn't. In many cases, the client accountant who was promoting the aggressive accounting had been the manager or partner on the job a few years earlier before taking the job with the client.

Let's illustrate our point of view.

Several years ago we met with Wayne Welsh, the internal auditor of the Utah state government, and he asked us if we understood "condition" and "criteria." We didn't know what he was talking about. Wayne then taught us what the words mean regarding internal auditing. "Criteria" are the way things ought to be based on best business practices. "Condition" is the way things actually are. The difference between the two is what internal auditors call a "finding." Wayne said the internal auditor must evaluate the situation and determine "criteria" based on his or her opinion of what the best practices would be. There's no rulebook for the internal auditor to use. Each situation is different and demands a different set of analysis skills, and the auditor must decide what the best practice is. In other words, as the PwC ad says, "A principles-based system requires companies to report and auditors to audit the substance or business purpose of transactions."

Now let's contrast the internal auditor's "criteria" with the external auditor's "criteria."

Under the present system, "criteria" in internal auditing would be principles-based accounting, and "criteria" to external auditors would be rules-based accounting. The external auditor refers to the rules: GAAP (generally accepted accounting principles). He or she then applies those rules, and, if there's any way to squeeze the client's practice into the confines of GAAP, the external auditor declares that the practice is "fairly presented in accordance with GAAP." The external auditor might not even agree with the financial statement presentation but supports it because somehow the company's management got it to fit within the rules. Or, in PwC's words, managers "can ignore the substance and, instead, ask, 'Where in the rules does it say I can't do this?'" There is no commitment to the rule for the external auditor as there must be a commitment to "criteria" for the internal auditor. The external auditor is unwilling to accuse the client of telling a lie even if he or she believes the presentation isn't truthful accounting. Thus we have "Enrons." Because the auditor didn't have to accuse the client of breaking a rule and was apparently unwilling to accuse him or her of telling a lie, the company's financial statements showed a profit when the firm was heading straight toward bankruptcy. …

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