The following article was first published in Compliance Week, 14 June 2016.
By Gary Kabureck
The debate over which accounting standards philosophy is better—principles or rules—has persisted for decades with no end in sight. It’s a healthy debate. Principles written at too high a level result in issues with comparability and other challenges but excessive rules result in unnecessary complexity and invite structuring.
Having spent 40 years in this space as a US auditor and preparer and for several years as an IASB member, I have the benefit of seeing this issue from several perspectives, and I have no doubt that a principle-based approach to establishing accounting standards is, without question, the better way to go.
However a principle-based approach is only successful when several pre-conditions are present—some technical, some mindset—which is the focus of this article.
It starts with a robust Conceptual Framework
Both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have well-developed and reasonably similar Conceptual Frameworks, providing overarching principles that cover many aspects of financial accounting at a high level. Among other objectives, they provide guidance to preparers and auditors for situations where standards-level guidance is nonexistent.
For example, the IASB Conceptual Framework is clear that an accounting policy determination needs to result in a representatively faithful outcome, one where substance over form prevails, is neutral and free of bias, complete in that all available information is considered, the result is verifiable, etc. It also provides concise definitions of assets and liabilities.
I could go on but my point is that to avoid a rule-based accounting regimen one must first have, which we do, a theoretically sound, sensible and understandable conceptual foundation which can be looked to for guidance by all process participants.
Accept that rules can’t cover everything
If they could, you wouldn’t need many financial accountants. A computer with a decision tree would do. Fortunately, no one is advocating this but the hypothetical question does raise a point: how many detailed rules are too many?
If the goal is to virtually eliminate non comparability, this is a pipe dream and completely unobtainable. Very detailed rules result in workarounds and structuring—think 89.9% versus 90% in current lease accounting—and they always will. If you write another detailed rule in response, this just becomes another workaround opportunity.
Where does it end? Remember the Derivatives Implementation Group which created several hundred pages of hair-splitting rules! The point is that detailed rules cannot answer everything and when they don’t, professional judgement enters the arena.
Furthermore, don’t forget that rules cannot prevent deliberate bad behaviour. Some of the largest financial accounting frauds of the past 15 years included some on-the-edge transactions, which were models of literal, technical compliance. Also, if the bad behavior mindset is 'stop me if you can' it really doesn’t matter what the rules say.
I’m not saying that detailed rules are never necessary but in general I believe they cannot be relied upon to consistently achieve their objectives and often sink under their own weight.
So, if a robust Conceptual Framework is the proper beginning and detailed rules too often miss their overall objective, then what is the path forward towards establishing and implementing principle-based accounting standards which produce comparable outcomes?
I think the answer is found in three interrelated steps: how standards are written, respecting judgement and understanding the most important needs of the primary users of financial statements. Here goes:
Clearly communicate accounting objectives when writing standards
This may seem obvious but is much easier said than done. I’ll use the expensing of employee stock options to illustrate the point as these complex and existing requirements are fairly recent.
We could simply require: 'employee stock options shall be charged to expense over the period earned' and while this is a principle it needs considerable development.
Preparers deserve clear guidance as to standard-setter intent in at least four Conceptual Framework pillars to properly account for in-scope transactions: measurement, recognition, presentation and disclosure. Accounting for equity-settled, grant-date employee stock option awards could hypothetically be written as follows:
Grant-date employee stock option awards shall be fair valued as of the grant date. Such fair value shall be recognised as an expense and a liability on a straight-line basis between the grant date and the vesting date. At the earlier of cancellation, exercise or expiry, any recognised liability is reclassified to equity. The fair value of outstanding awards shall be re-measured for any subsequent modifications which affect vesting expectations or value to the employee. Any such difference in fair value shall be recognised prospectively on a straight-line basis from the modification date to the vesting date.
Putting aside whether one agrees with this accounting, in 100 plain English words the above passage provides clear principle-based, primary accounting guidance for the entire life cycle of an employee stock option award, including: measurement (fair value), recognition (straight line), attribution period (grant date to vesting date) and presentation (first as a liability and later re-classed to equity).
Furthermore, it provides guidance for when the original conditions change. Of course, option awards are complex and while the above provides all the necessary critical guidance, there are usually lower-level decisions which also need to be made, which I’ll now discuss.
Respecting reasonable judgement
Where principle-based guidance ends, lower-level questions begin. Sometimes the answer will be obvious by reference to the Conceptual Framework and other times commonly accepted practices will emerge. In these situations comparability shouldn’t suffer, at least not when appropriate disclosures are made.
And then there is everything else; other transaction structures or anomalous situations for which, in theory, detailed rules could be developed (but probably can’t be on a timely basis), assuming the standard-setters can agree on what that guidance should be.
And just like today’s modern technology, which is obsolete tomorrow, the same is true of detailed accounting rules as new transaction types, creative terms and conditions and complex structures emerge almost daily. Application of judgement, guided by and within standards-level or conceptual boundaries, is the only plausible solution.
Judgement exists throughout current accounting. For example, in the IASB version of our two most recent major Standards, revenue recognition and leasing, the word ‘judgement’ appears almost 50 times. So, judgement is part of the process, but what type of judgement?
Maybe the most conservative choice is frequently the easiest to defend and document. However, always selecting the most conservative answer is clearly not what our Conceptual Framework intends.
The US audit standard for assessing management judgements is 'reasonableness', which to me is about the right mindset. But with reasonableness comes responsibility: management needs to be unbiased and objectively consider all available information; when executing their attest responsibilities auditors need to be respectful of reasonable client conclusions and not require extreme documentation or proof cases; and regulators need to accept reasonable accounting conclusions even if such weren’t their preferred outcome.
Finally, we as standard-setters need to provide sufficient principle-based guidance such that when judgement is necessary, the inevitable divergence in practice is limited. This brings me to my last point.
Comparability and the primary users of financial statements
A prime argument for rule-based standards is that in their absence, there will be a lack of comparability. However, as discussed above, it is not possible to write a rule for every occasion so some judgement and some variability in practice is inevitable.
But what do we mean by comparability? Comparability does not mean uniformity. In lay terms, comparability is being close enough to draw conclusions and not needing to worry about underlying differences. Accounting standards are established for the benefit of primary users, namely investors, creditors, lenders and other capital providers, to assist them in making buy, sell, hold or lend decisions. Those basic decisions are usually made based on a company’s total story and rarely on one piece of information or one isolated accounting judgement.
When viewed this way it is hard to envisage that any lack of comparability resulting from the type and magnitude of judgements advocated herein would make a material difference to primary users in the course of making asset allocation decisions. If an accounting outcome doesn’t make a material difference to the users’ analyses then, by definition, it is immaterial and any variation caused by reasonable judgements just doesn’t matter in the grand scheme of things.
Well-written, principle-based standards developed in conjunction with, and buttressed by, a robust Conceptual Framework will provide the guidance necessary to make virtually all material accounting decisions.
Considering the practical inability to have a rule for every possible situation, judgement is a critical part of the process and no one should be afraid of making, defending and accepting reasoned judgements.
Mr. Kabureck is a member of the International Accounting Standards Board (IASB). The views expressed in this article are his alone and do not necessarily represent the views of the IASB or individual IASB members.