Time to decide: Principles or rules?

Despite the tremendous amount of attention focused on the worldwide adoption
of international accounting standards, the past few years have witnessed very
little progress on the actual business of setting accounting standards.

Most of the work has concentrated on improving the standards inherited by the
International Accounting Standards Board from the International Accounting
Standards Committee – mostly achieved by removing or limiting choice – and
fiddling at the margin to help convergence with the US Financial Accounting
Standards Board through aligning agendas and interpretation.

The next five years will see a different stage of standard setting with 11
projects to be tackled. They include business combinations, fair value, revenue
recognition, post-retirement benefits, financial instruments, intangible assets
and leases.

According to IASB chairman Sir David Tweedie, there is one key question at
the start of this defining phase of international accounting standard
production. It is simply this: can the IASB produce principle-based statements?

This could hardly be called a new question; the term ‘cookbook approach’ has
been in existence to describe the fat standards produced by the US for at least
a decade. But in the international context this question will never be more
timely.

Sir David made it clear what he means by a principle-based standard, laying
out six criteria. Such a standard has to contain clearly defined core principles
and objectives. It is clearly in line with, and can be related back to, the
conceptual framework. It is one that has no exceptions and no inconsistencies.
The standard is accompanied by minimum guidance and, therefore, standard setters
will expect preparers and auditors to exercise judgement.

To attempt fully blown principle-based standards there would have to be some
material changes in approach and attitude by all users of accounts and financial
information. FDs and their staff, as well as auditors, would probably need
retraining. The ability to tease out which paragraphs of the standard, related
guidance and interpretation actually applies would be replaced by the need to
understand how to apply these shorter, principle-based standards without the
crutch of a detailed checklist. At the same time, preparers and users would have
to stop asking for more rules and interpretations to help with specific
industries’ situations.

There would have to be greater user sophistication and an acceptance that the
accounts had been produced using careful judgement rather than by thumbing
through a detailed rule book. Finally, capital markets regulators would have to
stop second-guessing accounting standard setters by adding on extra requirements
or greater disclosure. Such a change in attitude is a tall order.

Sir David also set out five ‘ifs’, which would lead the world inevitably and
irrevocably down the rules-based approach. If FDs and auditors don’t act with
integrity, if reasonable judgements are attacked and undermined through legal
challenges, if voluminous interpretations are provided, if the raw uneconomic
facts are unacceptable to the sensitive souls in the markets and if the
regulators insist on one answer, then rule-based standards it is.

If principle-based standards do win out, this will be Sir David’s most
enduring contribution to accounting, financial reporting and global capital
markets. Bob Herz, FASB’s chairman, supports principles versus rules on the
ground that such an approach produces better standards and better convergence.
But at heart, this is Sir David’s battle. He hates some accounting standards
with a long-standing passion. Take leasing. He claims that one of his ambitions
is to fly on a plane which is actually on the airline’s balance sheet. He claims
you could write a leasing standard on one side of A4 with the result that a
company entering into a lease would show on its balance sheet a liability and
the corresponding right to an asset. In his view, leasing has been hijacked over
the past 20 years by an unholy alliance of lawyers, merchant banks and
financiers who blatantly undermine the concept of substance over form and will,
if allowed, always do so through artificial devices.

Similarly he wants to replace the current standard on financial instruments
wanting to “improve and simplify and move towards a single measurement attribute
– fair value”. But it took 12 years for IASC to produce IAS 39 so there was no
way IASB could replace it in five minutes. Under his principles approach, an
accounting standard on financial instruments would have no EU brokered,
French-bank-inspired carve outs, no four ways of accounting for financial
instruments and would ban a choice of hedge accounting. But the result would be
raw, edgy accounting and huge volatility in earnings.

Make no mistake, Sir David raises this issue now because he is challenging
all stakeholders involved with standard setting to make a decision. If auditors,
regulators, analysts and FDs don’t fight now for principle-based standards then
the IASB won’t, can’t, produce them. The choice is yours.