From the February 2008 issue of Treasury & Risk magazine

Defining Principles

Buried in the recent Securities and Exchange Commission (SEC) publication of guidance for management on Sarbanes-Oxley was the admonition that companies should start to follow principles-based accounting, as long as it is compliant with Generally Accepted Accounting Principles (GAAP). Unfortunately, at this time, there is no meaningful definition of principles-based accounting for an executive to follow. Many people point to International Financial Reporting Standards (IFRS) as a model and want our system to converge with these standards. The concept sounds good in theory, but could result in either weaker U.S. rules or with so many exceptions that convergence would occur in name only.

Currently, the comprehensive list of principles to be applied to a U.S. business is so massive that it is not functional. For a list to be useful in a principles-based accounting environment, it would have to be adapted to GAAP in order for companies to meet the higher disclosure requirements in the U.S. Without a clear definition, even a well-meaning attempt at implementation is risking litigation, and some legal experts predict a surge in class action lawsuits when the switch is ultimately attempted. Worse, it also sets up a situation where companies could be interpreting the interrelationship between principles-based and GAAP very differently, making their financial results less comparable, but not necessarily obviously so.

These kind of vagaries help explain why the over-defined behavioral shelter of the rules-based system has held so much appeal for so many years. It's a "checklist" approach that provides a comfort level to risk-averse auditors.

So why are the SEC and other regulators pushing to make the switch? Hampered by the volumes of pronouncements designed to deal with increasingly sophisticated business transaction options, rules-based accounting has simply gotten so complex that it is no longer risk-free. One need only look at the many corporate debacles involving hedge accounting and Financial Accounting Standard 133 to see how well meaning companies can run afoul.

So maybe some change is needed, but principles-based accounting has many hurdles to clear before it will be the answer. One of the most obvious: Like it or not, companies and managements are rewarded today on their ability to manipulate numbers, and as long as that is true, principles-based accounting will end up being tied to rules.

If there are going to be significant benefits in moving toward a principles-based accounting structure in the U.S., we will first need substantial development of an infrastructure to train accountants and management in use of the standards and appropriate exercise of judgment. Without this, comparability of financial reports will be lost and fair presentation will be compromised.

Jerry Hutter, CEO of CFO Strategies, has over 40 years of experience as an auditor, controller, and consultant. He is a former certified public accountant with Price WaterhouseCoopers. Previous positions include financial controller for Home Savings of America (now Washington Mutual) and part of the corporate team at KB Homes. Prior to founding CFO Strategies, he led the CBIZ San Diego group handling Sarbanes-Oxley for accelerated filers. Hutter can be reached by going to www.cfostrategiesinc.com.

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