Making Principles-Based Accounting Standards Work

Back

Over the past year, there has been much talk about shifting the focus of accounting from rules-based to principles-based standards.  The Sarbanes-Oxley legislation requires the SEC to complete a study of the issue by next summer.  The Financial Accounting Standards Board has already begun to study the subject.  Many accounting experts believe that a change back to principles-based standards will force preparers and auditors of financial statements to focus on the intent of accounting standards and hopefully eliminate the gamesmanship of achieving technical but not substantive compliance.  Some point to international accounting standards as the model for a new, principles-based system.

At the same time, others are concerned about the risks of shifting to a principles-based system.  If companies feel pressured to boost earnings, then without specific rules, many would choose accounting methods that are less conservative.  The SEC’s Staff Accounting Bulletin 101 laid out very detailed rules to address perceived abuses to the principles-based revenue recognition standard that exists today.  Legal experts also worry that a shift to principles-based standards will lead to a surge in class-action lawsuits as aggrieved shareholders and corporations fight over the intent of the standards.

In order to get the benefits of a principles-based system and at the same time avoid its pitfalls, there must be adequate infrastructure to ensure that accounting standards are implemented effectively.  We should not expect this burden to be borne solely by auditors.  If it is to work now, investors - and especially professional investors at first - must play an important role.  However, this would entail a significant shift in the culture of the investment community that may be difficult to achieve in the current environment.

For thirty years or more, diversification and liquidity have been the bedrock principles of investing.  Diversification protects investors from a catastrophic loss on any given security.  Liquidity helps to ensure that investors can sell their shares when they see signs of trouble.  At the same time, however, these principles have fostered a trading-oriented culture that facilitated the deterioration in the quality of financial reporting. Diversification may shield investors from some losses, but it also keeps them from becoming more knowledgeable about their individual investments.  Improved liquidity makes it easier for investors to sell shares, but it also inhibits a longer-term investment perspective that might prompt the markets to take appropriate action early on to address developing financial problems.  Thus, despite the benefits, diversification and liquidity have helped to raise systemic risk.

This short-term mindset has become institutionalized.  For example, the standard practice in quarterly earnings announcements is for companies to issue a press release with limited information, often only one or two hours before conducting a conference call to discuss the results.  Evidently, it is more important under this system to get the news out so that the market can trade on it, then it is to have a complete discussion of the company’s financial performance.  If quality financial reporting was the primary goal, then companies would wait until they filed their complete financial statements with the SEC before holding their conference calls.

Changing this culture is obviously not a simple task; but several initiatives could be implemented to begin to shift the investment community’s focus:

First, institutional investors must begin to devote adequate resources to promote improved quality in corporate financial reporting.  Today, very few institutional investment firms have devoted the staff to respond to proposals by the FASB and other standard setters.  While individual analysts are technically responsible for monitoring the quality of financial reporting in the companies that they cover, in practice they often follow too many companies and are not encouraged to address financial reporting problems.  The lack of attention to quality control by institutional investors is surprising given the importance of financial reporting in the investment decision process.  In the past year, some firms have begun to hire people and dedicate staff to follow accounting issues, but the effort so far has been modest at best.

Second, the Association for Investment Management and Research (AIMR) should move quickly to re-start its Corporate Information Committee (CIC).  Up until 1996, the CIC brought security analysts together each year in industry subgroups to review the financial reporting practices of individual companies.  Participating companies would meet with the analysts and receive specific feedback on their entire investor communication efforts.  In several instances, these industry subgroups were able to get companies to expand their disclosure of key financial and operating metrics.  The CIC was disbanded in part due to concerns about legal liability, including AIMR’s assessment that the quality of the evaluations was not uniform across industry groups.  Some of these concerns can be addressed by changing the focus of the CIC, for example by scrapping the past practice of giving awards to companies in favor of identifying best practices and problem areas.  More importantly, however, the investment community must make a commitment to ensure that a reconstituted CIC is adequately staffed to do a quality job.

Third, corporations should provide an annual forum to discuss their financial reporting practices with the investment community.  As part of this forum, investors and analysts should have the opportunity to ask questions of the auditors.  While many will undoubtedly cringe at these ideas, there are precedents for them.  Not too long ago, many corporations regularly sought feedback on their financial reporting practices from the investment community.  I am not aware of any that do so today.  Most corporations also give shareholders the opportunity to ask questions of the auditors at their annual meetings.   Besides allowing investors and analysts a chance to get their questions addressed, such a forum might help companies improve the effectiveness of their financial reporting and perhaps even shrink the size of their financial reports.  It might also reduce future liability for both companies and their auditors.

Finally, all constituencies should support the growth and development of a strong independent research community.  While it is neither impossible nor desirable to eliminate all conflicts of interest, a well-established independent research community would be better suited to address financial reporting concerns.  As such, it could play an important role in ensuring quality in financial reporting.

These proposals would go a long way toward providing the infrastructure that is necessary to support a shift towards principles-based standards.  By institutionalizing an active quality assurance role for investors and analysts and regularly monitoring compliance across all companies and industries, we would gain additional safeguards to ensure the effective implementation of principles-based standards.  Some suggest that the institutional investor community faces too many potential conflicts of interest that would hinder its taking on such an active role.  If so, then the notion of principles-based standards may not succeed.  But if institutional investors can work through these conflicts and strengthen their quality control efforts, then it just may be possible to both simplify and improve financial reporting.

Back

Please send your comments and suggestions to: webmaster@larkresearch.com.