Ethics, Professionalism, and Principles based Standards

1
Ethics, Professionalism, and Principles-based
Standards

• Cynthia Jeffrey

2

• What is ethical judgment?
• What is professional judgment?
• Do these phrases mean the same thing, are they
  related, or do they each mean something different?

3
Case

• Chris Gibson has been employed by the public
  accounting firm of RST for the past four years
  and is the senior in-charge of the Greenwood
  Manufacturing Company audit for 2004. Greenwood
  is a manufacturer of household furniture and a
  division of a large, publicly traded corporation.
  With annual sales of approximately 40 million,
  Greenwood is in good financial health and the
  corporation has received unqualified audit
  opinions in recent years.

4

• While visually inspecting the accounting records
  of Greenwood in a search for unusual appearing
  transactions, Chris discovered an uncoded cash
  disbursement of 25,000. Chris decided to
  discuss the situation with the controller, Kelly
  Johnson.

5

• Kelly Johnson first worked for Greenwood
  Manufacturing when it began operations in 1970.
  Johnson has held the controllers' position for
  eight years and is generally regarded as one of
  the most competent and highly respected
  executives at Greenwood. Johnson has always been
  cooperative and professional during the course of
  the audit.

6

• Kelly Johnson was alone in his office when Chris
  Gibson entered and referred to the 25,000
  disbursement. Johnson asked Chris to close the
  door, pulled a file from his desk, and then began
  the following conversation

7

• "I expected you might be dropping by to discuss
  that withdrawal. The disbursement is my personal
  responsibility and I repaid it the next day. You
  can verify the receipt by examining the bank
  statement. I have copies of all supporting
  documents in this file. I withdrew those funds
  from the company account after receiving a phone
  call that afternoon from my son, a student at the
  university. At the time, I was unaware he had
  developed a severe gambling problem. He told me
  that he had substantial losses which he was
  unable to pay. Furthermore, he had been
  threatened with bodily harm if he didn't pay
  25,000 in gambling debts by that night. The
  only way I could obtain that much cash in a
  matter of hours was to access company funds. I
  repaid the amount the following day with personal
  funds. My son has since obtained counseling and
  treatment for his gambling problem. You are the
  only person I've confided in you must realize
  that I will lose my job if this matter becomes
  public."

8

• Chris confirmed that the support from Johnson's
  file was consistent with his explanation.
• What do YOU think???
• A Chris SHOULD NOT disclose the disbursement.
• B Chris SHOULD disclose the disbursement.

9

• What issues might you consider in making a
  personal ethical choice about this dilemma?
• What issues should you consider in making a
  professional judgment as to how to resolve this
  dilemma?

10

• You might not necessarily make the same choice if
  you were considering strictly your personal value
  system, as opposed to the values of the
  profession.

11

• Ethical reasoning is a function of personal
  values, and professional judgment is concerned
  with professional values.
• Professional commitment is seen as a
  socialization process when the norms and values
  of the profession are learned and accepted by new
  entrants.

12

• Often, there is no single correct answer to an
  accounting dilemma.

13

• Remember when you were a student in Intermediate
  Accounting and were facing problems requiring you
  to calculate the amortization of interest on a
  capital lease, or to calculate earnings per
  share?
• While those problems were challenging, too often
  studentsand accountantsthink that solving those
  questions is the goal of accounting.

14

• We tend forget that the hard part of those
  problems was already completed when they were
  assigned to the classthe information in the
  paragraph that already provided revenues,
  expenses, appropriate interest rates, and all of
  the details needed to solve those technical
  problems.
• Accounting is really about finding the
  information that goes in that paragraph and
  making sure that it is a fair representation of
  the underlying economic substance.

15

• Too often, those in the profession seem to think
  that accounting is a rules-based activity, and
  that there is a right answer to any given
  question.
• Instead, it is an ill-structured discipline, with
  significant emphasis on judgments.

16

• We need to think carefully about what drives
  those judgments, and to think about what it means
  to make professional judgments.

17
Professionalism

• Professionalism, and Professional Judgment, are
  ethical constructs.

18
What Does It Mean to Be a Professional???

• Service, ethical training, and high prestige
  based on the use of esoteric skills are
  considered by social scientists as major
  indicators of professional status.

19

• Intuitively, a business provides a service to
  please a customer and ultimately at the bidding
  of a customer alternatively, a profession serves
  the public interest by adhering to an ideal.

20

• A profession at some level involves a commitment
  of service to the public that goes beyond the
  test of the market or the desire for personal
  profit Hatch 1988. As early as 1926, Taeusch
  1926 distinguished between the professional and
  the business person as a function of the
  importance of rendering of services relative to
  the assurance of fees and charges.

21

• Bennion 1969 notes that professionals long
  refrained from indulging in activities perceived
  as "commercial" because these activities are
  considered less "professional." He claims that
  "Trade' has been used as a term of opprobrium
  throughout the modern history of the profession."

22

• Camenisch 1983 discusses the "atypical moral
  commitment" expected of a professional--that he
  or she is assumed to be sufficiently committed to
  some good larger than his or her own
  self-interest or preferences.

23

• Kultgen 1988 discusses the professional ideal,
  stating that the goal is to make "service the
  direct and controlling object of professionalism,
  to prevent profit and wages from being so by
  making them its routine byproducts" .

24

• So Professionalism includes an ethical component,
  but rather than making decisions based on an
  individuals ethical beliefs, the professional is
  expected to make judgments that conform to the
  values and standards of the profession.

25

• There can be no true professionalism without
  attention to ethics.

26

• Back in the late 80s, I saw a survey that
  indicated accountants were considered among the
  most ethical of all professionalsin the top 5,
  right next to clergy. Do you think accountants
  were near the top when that survey was repeated
  in 2000?

27
Top 10

• Doctor
• Nurse
• Teacher
• Fireman
• Military Officer
• Scientist
• Police Officer
• University Lecturer/Professor
• Clergyman (incl. Minister/Priest/Rabbi)
• Librarian

28
Next 10

• Airline Pilot
• Author
• Postman
• Chemist
• Architect
• Dentist
• Computer Programmer
• Child Care Worker
• Social Worker
• Carpenter

29
Next 10

• Chef
• Optician
• Waiter/Waitress
• Film Cameraman
• Landscape Designer
• IT Technician
• Tax Collector
• Retail Store Owner
• Bank Teller
• Retail Shop Manager

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The rest of the top 40

• Bartender
• Web Designer
• Corporate Manager
• Interior Designer
• Radio Announcer
• Actor
• Taxi Driver
• Call Center Worker/Telemarketer
• Local Government Official
• Traffic Cop

31
And here we areNo. 43

• Bank Manager
• TV Newscaster
• Accountant
• Company Director
• Car Dealer
• Marketing Executive

32

• Accountants were down to number 43 in the top 46,
  just ahead of company directors, car dealers, ,
  and marketing executives.

33

• What has happened to our profession?!?!
• Cendant, Waste Management, Sunbeam, Adelphia,
  WComm, Global Crossing, ENRON.

34

• AICPA President Barry Melancon, in a speech
  immediately following the passage of
  Sarbanes-Oxley, remarked

35

• We are committed to rebuilding confidence in the
  financial markets and their institutions. Were
  committed to dramatically reducing the risk that
  future investors will fall prey to the kind of
  financial malfeasance that characterized Enron
  and WorldCom. And we are committed to something
  else as well restoring pride in our profession.
  For us, it is personal.

36

• How do we go about doing this???? Melancon goes
  on to state
• What is needed is not just reform of the
  accounting laws, it is a rejuvenated accounting
  culture, both internally in corporate finance
  offices and externally in audit firms. The
  culture must build on the professions
  traditional values, such as rigorous commitment
  to integrity,

37

• a passion for getting it right, a commitment to
  rules not just to their letter, but their
  spirit, and zero tolerance for those who break
  them.

38

• Arthur Levitt, former Chair of the SEC, in a
  speech at NYU on September 28, 1998 entitled The
  Numbers Game stated

39

• Too many corporate managers, auditors, and
  analysts are participants in a game of nods and
  winks. In the zeal to satisfy consensus earnings
  estimates and project a smooth earnings path,
  wishful thinking may be winning the day over
  faithful representation.

40

• As a result, I fear that we are witnessing an
  erosion in the quality of earnings, and
  therefore, the quality of financial reporting.
  Managing may be giving way to manipulation
  Integrity may be losing out to illusion.

41

• The cracks in the foundation of our profession
  were forming long before Levitts comments,
  before the recent scandals with the screaming
  headlines, back, perhaps to the 70s and 80s.
• By looking back at how we got to this point, we
  can better understand what needs to be done to
  restore the values of our profession.

42

• We can look at what happened to Arthur Andersen
  to see what has happened to the profession as a
  whole.
• The downfall of Andersen crystallized an
  awareness of some of the things that are wrong
  with our profession today.

43

• It is ironic that largest penalty in the rash of
  accounting scandals was the demise of Arthur
  Andersen. Prior to the 1990s, Andersen had a
  long-standing reputation for criticizing its own
  competitors as too lax.

44

• In the book, Inside Arthur Andersen, the authors
  describe what they refer to as the partner
  purge of 1992. At that time, the firm
  established a criterion for Andersen partners of
  handling 20,000 billable hours per year.
  Partners who were unable or unwilling to do so
  were asked to leave.

45

• About 10 of Andersen partners left the
  firmincluding the most conservative partners
  with traditional values. This was coupled with
  an increase in the importance of revenue
  generation through sales of services for
  performance evalution.

46

• When Andersen fired these partners, the firm lost
  expertise through which quality was taught and
  learned. Further, there was change in the
  balance between youth and experience.

47
Motivations

• Arthur Wyatt ( past chair of the IASC, past
  member of the FASB, past member and chair of the
  AICPAs Accounting Standards Executive Committee,
  Retired Partner from Arthur Andersen, faculty of
  UIUC, inducted into the Accountants Hall of Fame
  in 1998) suggested the following motivations for
  the decline and fall of professionalism

48

• Corporate and individual greed
• Delivering services that acted to impair
  independence
• Becoming too cozy with clients
• Participating actively in ways to avoid fair
  presentation

49

• When Wyatt graduated from college, he noted that
  Andersen was the 12th largest firm, with about 30
  partners. By the 1960s, it was part of the Big
  8, with about 350 partners worldwide.
• Is firm size an issue? Is growth an issue?
• There is nothing wrong with size or growth. The
  problem is when the importance of those variables
  supersede the importance of professionalism.

50

• When Wyatt entered the profession, most entrants
  into the professional were recent college
  graduates and the curriculum in accounting had a
  strong focus on professional ethics.
• Promotion was based on technical skill,
  experience, and knowledge about diverse
  accounting issues.
• How does that compare to today? (after the
  purge)
• It isnt size, or growth, that is the issue, but
  rather the relative importance placed on these
  variables in defining the accounting environment.

51

• Wyatt notes that when he joined the profession,
  professionals spoke out forcefully on the issues
  of the day without regard to client positions on
  those issues.
• Reputations were gained, in part, from a firms
  policy on taking a tough stance on the
  interpretation and application of accounting
  standards.

52

• Wyatt remembers when Andersen would resign from
  the audit of a major client because they
  disagreed with reporting decisionsa railroad, a
  savings and loan.
• Wyatt believes the underlying culture at Andersen
  was the belief that clients wanted the auditor to
  keep them out of trouble and expected them to
  take a tough stance on problematic issues.

53

• Through the 1970s, accountants could not
  advertise their services.
• I remember the door to my dads officegold
  lettering, on the glass door, Paul Pettengill and
  Company, CPAs. That was it. And a one-line
  listing in the yellow pages.
• During this time, accountants did not steal
  clients from competitors
• Does advertising matter?

54

• Spending by the biggest CPA firms for ads to lure
  clients has risen from 4 million in the early
  1980s to more than 100 million by the start of
  2003 (Chicago Sun Times, January 13, 2003,
  Advertising has Hurt Accounting Ethics)

55

• The firms claim that
• Advertising brings in added revenue so that they
  can improve services, and give their auditors a
  sense of independence that allows them to be
  tougher with clients while remaining
  competitive with other consultants.

56

• Critics claim that the emphasis on selling
  services and increasing revenues has made
  accountants susceptible to client pressures.
  Some claim that Clients are wiling to pay huge
  fees for consulting to keep auditors from looking
  too scrupulously at the company books.

57

• Arthur Bowman, editor of Bowmans Accounting
  Report in Atlanta
• Accounting-firm advertising seems to stress that
  its more important for accountants to make money
  than to serve the public ethically through
  effective auditing.

58

• Douglas Carmichael, Director of the Center for
  Financial Integrity at Baruch College in New
  York
• Increased advertising by major accounting firms
  has permitted the business side of accounting to
  take over the professional side.

59

• A report by the SEC in 2000 concluded that the
  practice of auditing wasnt being regarded highly
  enough by the big accounting firms, and claimed
  that auditors werent working hard enough to
  prevent fraud at their client companies.

60

• Certainly, blaming the problem on advertising
  alone is not realistic, but Jay Nisberg, a
  Ridgefield, CT consultant, concedes that the
  increase in advertising to attract business has
  likely detracted from the focus of quality client
  service.
• Again, it isnt advertising per se that is the
  culprit, but rather the relative importance of
  fee generation and growth of revenues relative to
  the service ideal that is intrinsic to
  professionalism.

61

• Bowman points out that accounting firms began
  hiring marketing specialists from consumer
  product companies who knew little about
  auditings strict rules.
• This was one more force influencing the culture
  of audit firms and accountants that tended to
  erode the importance of professionalism.

62
What Changed?

• Consulting
• What is the impact of consulting? It is about
  more than generation of revenues.
• Independence? Is it impaired?
• Differences in characteristics of people hired by
  firms
• New college graduates vs. experienced (and
  remember the nature of the curriculum)
• Accounting background
• CPA designation

63

• Consulting grew more rapidly than core accounting
  and tax areaswhich means more and more firm
  revenue came from consulting
• What does this do to our ability to say no?
• What does this imply about the mix of people
  working in a firm?
• And what does this imply about the socialization
  process whereby professional values are learned?
  
• Again, this does not PRECLUDE professionalism,
  but it is another change in the culture of
  accounting firms that may tend to erode the
  importance placed on professionalism.

64

• Bogle (2000) noted that over the years,
  attestation came to account for only about 1/3 of
  the 26 billion in revenues earned by the Big 5
  accounting firms in 2000, with tax services
  supplying another 25 and another 40 from
  consulting, management, and advisory services.
• Not only does this raise questions about
  independence, but it also appears to signal a
  shift from the service ideal of professionalism
  to the profit motivation of a business-partner
  relationship.

65

• At Andersen, Wyatt saw a change in focus from a
  central emphasis on delivering professional
  services in a professional manner to an emphasis
  on growing revenues and profitability.
• Auditors became more willing to assume additional
  risk in order to maintain their revenues.

66

• I believe this attitude permeated all levels of
  the profession, not just Andersen and the other
  accounting firms. I remember an article in
  Journal of Accountancy that recommended cutting
  clients who would not buy additional services and
  therefore would not contribute to growth of the
  practice.

67

• The changes were slow, and initially seemed to be
  no more than the profession adapting to changes
  in society and the economy.
• But these changes were so much more!

68

• One journalist, Steven R. Strahler, (Cranes
  Chicago Business, October 7, 2002) points to 1992
  as an illustration in the shift of attitudes at
  Andersen, which is indicative of the changes that
  had occurred in the profession.

69

• When the FASB announced its intention to issue a
  standard that required expensing of stock
  options, regulators were hardly shocked when
  Silicon Valley firms raised strenuous objections.
  However, what dismayed them was high-techs new
  ally in the fight, the supposedly impartial
  accounting industry.

70

• Charles Bowsher, an Andersen alum who went on to
  chair the professions Public Oversight Board,
  stated
• Andersen went along with the other firms in
  scuttling those rules. That was the watershed of
  Andersen changing their attitude, their
  leadership on professional issuesright then.

71

• Wyatt, who was then a member of an internal
  standard setting-body at Andersen remembers being
  in his Chicago office, nearing retirement in late
  1992, when one of the guys came in and said we
  had to change our view on it. The rationale
  given was, we had too many clients unhappy with
  the previous position we had taken.

72

• Wyatt, in 2002, stated I had absolutely no idea
  that this was going to lead to what it led toin
  and of itself, it didnt matter a whole hell of a
  lot. It was what it was indicative of.

73

• One result was the resignation, en masse, of
  members of Andersens independent review board.
• Strahler notes that, to some, this symbolized the
  grip that technology clients had gained on the
  firm, not as an auditor but as a consultant
  reaping head-spinning fees.

74

• What did this portend for Andersen, and for the
  profession?

75

• Being profitable doesnt mean one isnt ethical,
  or is incapable of sound professional judgment.
• But profits should be an expected outcome of
  sound business practices.
• Andersen lacked leaders who would stand up to
  management, and put profits and keeping the
  client happy above the need for sound
  professional judgment.

76

• So, we are back to the motivations Wyatt
  identified in his 2003 speech
• Corporate and individual greed
• Delivering services that acted to impair
  independence
• Becoming too cozy with clients
• Participating actively in ways to avoid fair
  presentation

77
What Can We Do?

• Robert Herz, Chairman of the FASB, April 8, 2003
• People forgot they had a sacred role in making
  sure the information was right, was as good as it
  could be, said Herz. People are re-recognizing
  these sacred roles, whether they are auditors or
  analysts. But theres a lot of trust and respect
  to be earned back.

78
Education

• Education Ethics training has been primarily
  left to colleges and universities, and not at the
  firm level
• However, it is not until the accountant starts
  working in the firm that they are really able to
  experience the pressures and incentives they
  face, which again makes the ethical climate at
  the firm critical.
• This suggests the need for additional ethical
  training AFTER students have left the University.

79

• It is not enough that a practitioner follow the
  rules no matter how detailed those rules may be.
• Given the multitude of changes in the business
  environment over the last 50 years, the pressures
  and potential risks facing accountants have
  changed and, perhaps intensified.

80

• Many have claimed that a reaffirmation of the
  primacy of principles over rules is essential to
  reform. William McDonough, the first Chairman of
  the PCAOB, stated in an address to the Financial
  Executives Institute in 2004 Our goal is to
  help practitioners better understand the
  principles underlying the standards and
  appreciate why it is important that they use
  judgment in applying them.

81

• We (the PCAOB) expect auditors and issuers alike
  to exercise judgment.
• James Quigley, of Deloitte Touche, stated that
  legislation can only be part of a larger effort
  that includes a return to principles-based
  accounting.

82
Principle-Based Standards

• The idea of a principles-based approach to
  standard setting is not new.
• The concept requires a return to the Conceptual
  Framework that describes the purpose and goals of
  financial reporting.
• The conceptual framework is over 20 years old,
  and its influence on GAAP has been significant.

83

• IT is likely to be even more significant in the
  future, and is in need of evaluation and
  improvement, and the FASB is again working on the
  Conceptual Framework.

84

• In 2001, The Annual Financial Accounting
  Standards Advisory Council Survey, respondents
  indicated that the FASB needed to place a high
  priority on finding ways to codify and simplify
  the accounting literature.

85

• A key issue is standards overload, which
  includes issues related to
• The level of detail and complexity in accounting
  standards
• The amount of interpretive and implementation
  guidance for applying standards issued by
  standard setting bodies other than the FASB,
  including the EIFT, the AcSEC (AICPA Accounting
  Standards Executive Committee), and the SEC
• Difficulty in retrieving all accounting
  literature on specific topics
• Disclosure overload

86

• At its January 9, 2002 meeting, the Board decided
  to address the broad issue of standards overload
  through a series of initiatives.
• A key proposal is the consideration of adopting
  an Principles-Based approach to setting
  standards.

87

• This initiative was later mandated by
  Sarbanes-Oxley, which required the SEC to conduct
  a study on the adoption of a principles-based
  approach in the U.S and to submit a report on the
  results of the study to the Congress by July,
  2003.

88

• The general feeling of the board is that
  principles-based standards
• Should have few, if any exceptions
• Would mean that the FASB (and others) should
  provide less interpretive and implementation
  guidance
• Would require the use of more professional
  judgment

89
The Proposal

• In October, 2002, the FASB issued a Proposal,
  Principles-Based Approach to U.S. Standard
  Setting. The comment period for the proposal ran
  through January 3, 2003.
• The proposal and the comment letters are
  available on the FASB web site.

90

• The proposal discusses a principles-based
  approach to standard setting to improve the
  quality and transparency of financial accounting
  and reporting in the United States.

91
Points in the Proposal

• A principal concern is that accounting standards,
  while based on the conceptual framework, have
  become increasingly detailed and complex.
• Difficult for accounting professionals to remain
  current
• Accounting standards are difficult and costly to
  apply

92

• Further
• Many suggest that because much of the detail and
  complexity in accounting standards results from
  rule-driven implementation guidance, the
  standards allow financial and accounting
  engineering to structure transactions around
  the rules, thereby circumventing the intent and
  spirit of the standards.

93

• Harvey Pitt, former SEC Chair
• Much of FASBs recent guidance has become
  rule-driven and complexthis emphasis on detailed
  rules instead of broad principles has contributed
  to delays in in issuing timely guidance.
  Additionally, because the standards are developed
  based on rules, and not broad principles, they
  are insufficiently flexible to accommodate future
  developments in the marketplace.

94

• The Board notes that much of the detail and
  complexity in accounting standards has been
  demand-driven, resulting from
• Exceptions to the principles in the standards
• The amount of interpretive and implementation
  guidance provided by the FASB and others

95

• Much of the guidance provides rules that
  establish bright lines that focus on the form,
  rather than the substance, of the transactions.
• (lease accounting, consolidation of SPEs)

96

• The main reason for interpretive and
  implementation guidance in accounting standards
  is to ensure some level of comparability.
• (Where are we these days with comparability? Is
  this a valid goal? Should it be?)

97

• Some believe that bright lines are particularly
  important in a litigious environment.
• Detailed guidance provides the SEC with an
  effective enforcement mechanism
• Detailed guidance may limit the ability of the
  SEC and others, including the Courts, to second
  guess professional judgments.

98
Accounting Standards Developed Under a
Principles-Based Approach

• The principles reflecting the fundamental
  recognition, measurement, and reporting
  requirements of the standards would continue to
  be developed using the conceptual framework.
• Principles would apply more broadly than under
  existing standards
• There would be few, if any exceptions to the
  principles
• There would be less guidance (from all sources,
  not just the FASB) for applying the standards
• Increased professional judgment would be required.

99

• The FASB states, Although the FASB has used its
  conceptual framework in developing accounting
  standards, that framework has not provided all
  the requisite tools for resolving accounting and
  reporting problems. In part, that is because
  certain aspects of the conceptual framework are
  incomplete, internally inconsistent, and
  ambiguous.

100
Examples

• CON 2 Qualitative Characteristics of Accounting
  Information
• Relevance, Reliability
• (Predictive value, Feedback value, timeliness,
  Neutrality, Representational Faithfulness,
  Verifiability)
• Consistency, Comparability

101

• While the statement attempts to define these
  constructs, it does not provide conceptual
  guidance necessary for making tradeoffs among the
  qualities of relevance and reliability,
  consistency and comparability.

102

• When defining elements of financial statements in
  CON 6 (assets, liabilities, owners equity,
  revenues, and expenses) the FASB emphasized the
  balance sheetrevenues and expenses are defined
  in terms of balance sheet items

103

• Revenues inflows of assets resulting from
  business operations
• (Old definition the price of goods and services
  rendered)
• Expenses outflows of assets resulting from
  business operation
• (Old definition expired cost)

104

• This change to an emphasis on the balance sheet
  was a significant change in thinking about
  financial reporting. When this statement was
  issued, there were those who thought the Balance
  Sheet had become irrelevant! (Inflation, etc.)
• Can you ever really understand the income
  statement without understanding comparative
  balance sheets?

105

• However, the revenue recognition guidance in CON
  5 is a description of accrual accounting, and is
  transaction based. Revenue is earned when the
  transaction is completed, and expenses are
  matched to revenue in the same reporting period.

106

• If income is defined as a change in net assets,
  which seems to be implied when revenue and
  expenses are defined in terms of increases and
  decreases in assets, the accrual accounting
  concepts in CON 5 are inconsistent.

107

• Because of compromises necessary to issue it, the
  guidance in FASB Concepts Statement No. 5,
  Recognition and Measurement in Financial
  Statements of Business Enterprises, includes a
  description of practices existing at the time,
  providing little, if any, conceptual basis for
  analyzing and resolving the controversial issues
  of recognition and measurement.

108

• Among other things, Concepts Statement 5 does not
  provide the requisite tools for assessing whether
  items should be measured at fair value and, if
  so, when
• If income is to be a function of asset inflows
  and outflows, what happens when assets are not
  measured fairlyor measured at all? (i.e.,
  internally generated intangible assets)

109

• The conceptual framework does not include a
  framework for developing disclosure requirements.
• Yet full disclosure is a key concept in
  financial reportingall necessary information to
  allow users to interpret the financial position
  and operating results of a company.

110
Key Issue

• Most feel that accounting standards with
  principles that apply more broadly than under
  existing accounting standards would require a
  conceptual framework that is complete, internally
  consistent, and clear.

111
Exceptions

• The hope is that accounting standards with few,
  if any, exceptions to the principles would lead
  to more situations in which similar transaction
  and events are accounted for similarly, thereby
  enhancing comparability and reducing the level of
  detail and complexity that arises from exceptions.

112

• Because exceptions are provided to achieve
  desired accounting results (for example, to limit
  the volatility of reported earnings that would
  result by applying the principles in the
  standards) they may obscure the underlying
  economics of the related transactions and events
  covered by the standards.

113

• So why do you think there are a lot of
  exceptions?
• Do you think this would be more or less of a
  problem with more general standards?

114
Robert Sprouse

• I submitthat minimizing the volatile results of
  actual economic events should be primarily a
  matter for management policy and strategy, not a
  matter for accounting standards. To the extent
  volatile economic events actually occur, the
  results should be reflected in the financial
  statements. If it is true that volatility
  affects market prices of securities and the
  related costs of capital, it is especially
  important that, where it actually exits,
  volatility be revealed rather than concealed by
  accounting practices. Otherwise, financial
  statements do not faithfully represent the
  results of risks to which the enterprise is
  actually exposed.

115

• To me, the least effective argument one can make
  in opposing a proposed standards is that its
  implementation might cause managers or investors
  to make different decisions...

116
Microsoft

• Microsoft agrees that exceptions to the
  principles have also contributed to the problem,
  but notes that it is important to understand the
  exceptions in light of the overriding goal of
  providing information that is useful to present
  and potential investors and creditors. . . In
  regards to the issue of exceptions, the Proposal
  indicates the following

117

• Other participants in the U.S. financial
  accounting and reporting process, including
  preparers, investors, creditors, and other users
  of financial information, must accept the
  consequences of applying accounting standards
  with fewer exceptions, including increased
  volatility of reported earnings.

118

• Microsoft does not believe that reporting
  volatility per se is undesirable, but it is
  important to determine whether that volatility is
  a faithful representation of the phenomenon it
  purports to represent. With respect to the
  statement by Robert Sprouse, wouldnt the reverse
  also be true? That is, it is especially
  important that, where it does not actually exist,
  volatility should not be created by accounting
  practice?

119

• Microsoft notes specifically the exceptions with
  respect to accounting for derivatives, whereby
  derivatives used for hedging are accounted for
  differently than derivatives used for
  speculation. This has been one of the issues
  cited with respect to exceptions. Microsoft uses
  derivative securities to hedge against various
  risks of doing business overseas, which, if used
  correctly, should reduce the volatility of their
  reported earnings. However, if hedging
  derivatives were not treated as an exception, the
  use of derivative securities would increase the
  volatility of reported earnings.
• (One related question might be to consider the
  volatility of underlying cash flows.)

120

• So the Board would need to resist pressures to
  provide exceptions, as well as making
  determinations as to how broad the principles
  should be.

121
Reduced Guidance

• The Board believes that as exceptions and other
  complexities are phased out, there would be less
  need for complex guidance.

122
Dissent to SFAS 66

• Mr. Walters dissents to the issuance of this
  Statement primarily because he objects to
  incorporating these complex, rigid, and detailed
  rules into accounting standards. Entirely aside
  from the conceptual merit of these rules, which
  is at least debatable, he believes the Board
  should focus at about the level expressed in
  paragraphs 3 and 4 of this Statement. Beyond
  that, he believes the accounting profession can
  serve its members by offering more specific
  guidance for applying the standards in particular
  specialized areas, but such detailed and
  arbitrary guidelines should not be dignified as
  accounting standards. To do so debases
  accounting standards and inevitably will diminish
  the stature and effectiveness of the accounting
  profession, whose strength and purpose arise from
  applying broad accounting and reporting
  objectives to specific circumstances with
  professional judgment and objectivity. That
  judgment is the hallmark of a true professional.

123

• What do you think?
• What are the pressures on accountants?
• Are we professionals? What is meant by
  professional?
• Can we be expected to act as professionals?
• Can principle-based standards work?

124

• Will principles-based standards improve financial
  reporting?

125
Comparability

• Professional judgments, made in good faith, could
  lead to different interpretations for similar
  transactions and events.

126
Standard-Setting

• Absent additional guidance and bright lines,
  those other than the FASB who have the requisite
  resources and expertise to develop interpretive
  and implementation guidance might become de
  facto standard setting bodies and develop
  guidance without the due process provided by the
  FASB.

127

• Each firm might determine how a particular
  transaction would be handled?
• AICPA
• SEC

128

• There may be inefficient use of resources as many
  different people consider the same questions
• Small firms may not have the same resources to
  evaluate issues that large firms have.
• Small corporations may not have the same
  resources to evaluate issues that larger
  corporations have

129

• Potential for abuse?
• Professionalism, vs. lack of good faith and
  concern for client interests, rather than the
  interests of financial statement users.

130

• Understandability? Will it increase or decrease?
• Will principle-based standards more clearly
  convey economic substance?

131

• Implementation? What might be the issues here?

132
Convergence

• Another issue that has been raised with respect
  to the Principles-based Standards initiative is
  the potential impact on convergence of accounting
  standards internationally.

133

• In the post-Enron world, many have pointed to the
  stance taken by the International Accounting
  Standards Board (IASB)
• Sir David Tweedie, Chairman of the IASB,
  testified before the U.S. Senate Committee on
  Banking, Housing and Urban Affairs

134

• Many International Financial Reporting Standards
  (IFRS) are similar to U.S. GAAP. Both
  international standards and U.S. GAAP strive to
  be principles-based, in that they both look to a
  body of accounting concepts. U. S. GAAP tends,
  on the whole, to be more specific in its
  requirements and includes much more detailed
  implementation guidance.

135

• We favour an approach that requires the company
  and its auditor to take a step back and consider
  whether the accounting suggested is consistent
  with the underlying principle. This is not a
  soft option. Our approach requires both
  companies and their auditors to exercise
  professional judgment in the public interest.
  Our approach requires a strong commitment from
  preparers to financial statements that provide a
  faithful representation of all transactions and a
  strong commitment from auditors to resist client
  pressures. It will not work without these
  commitments. There will be more individual
  transactions and structures that are not
  explicitly addressed. We hope that a clear
  statement of the underlying principles will allow
  companies and auditors to deal with those
  situations without resorting to detailed rules.

136
IASB

• One issue is that they havent been around as
  long as the FASB!
• Also, the IASB has diverse membership, and it is
  difficult to get them to vote to pass a detailed
  standard.

137
International Convergence

• Might principle-based standards in the U. S.
  facilitate convergence efforts internationally?

138

• Certainly, to the extent that the FASB works with
  the IASB and other national standard setters in
  developing common high-quality accounting
  standards, convergence could be facilitated.

139
SEC

• Are there incentives for the SEC to second
  guess application of relatively broad standards?
• (Revenue recognition)
• Are there incentives for the SEC to accept
  principle-based standards?

140

• Is it a problem if groups other than the FASB
  acquire a significant influence on standards by
  developing guidance?
• Quasi-standard setting by diverse groups
• Rules not codified or subject to due process
• second guessing

141
Definition

• Do you feel that the concept of principle-based
  standards is well-defined at this time?

142

• What is the difference between principle-based
  standards and our current GAAP? Is that not
  based on principles?
• (you might note that there are currently over 140
  different pronouncements from FASB, SEC, and
  others on when a company can book revenue)

143
Timing

• Is the timing right?
• Will principle-based accounting standards be
  accepted by the investing public? Will people
  trust companies financial reporting if there
  arent clear rules that have to be followed?

144
Costs?

• Preparers
• Wading through existing standards, vs. debating
  interpretation and implementation potential
  litigation costs
• Users?

145
International Brotherhood of Teamsters

• The current rules-based system is riddled with
  exceptions and even exceptions to the exceptions.
  The system is full of loopholes, and frequent
  rule changes make it difficult for even the most
  diligent accounting professional to remain current

146
AICPA

• There may be a significant net increase in
  divergence, however, if the Board conceptualizes
  principles-based at too high a level. That is a
  major concern because comparability affects
  greatly the usefulness of financial statements. .
  . We believe that recent FASB exposure drafts on
  guarantees and special-purpose entities lacked
  clarity, and we hope that those proposed
  pronouncements will not serve as models for the
  principles-based approach.

147
Itzhak Sharav, Professor, Columbia University

• We have already two such overarching principles
  (1) The requirement of full and fair disclosure,
  which means that in the preparation of financial
  statements, one ought to follow not only the
  letter, but also the spirit of GAAP. (2) The
  materiality principle, according to which an item
  is material if its inclusion in the financial
  statements, or exclusion from them, is likely to
  affect the judgment of the reader.

148

• True adherence to these two broad principles
  would have ruled out recognition of revenue
  prematurely, and other falsifications of the
  financial statements that came to light recently.
  The question that the SEC study and the FASB
  will have to address, therefore, is whether the
  elimination of our present rule-based system,
  despite its admitted imperfections, will inspire
  greater adherence to the spirit of GAAP, or will
  it result in more misleading financial
  statements, in the knowledge that absent detailed
  rules, it might be easy to engage in accusatory
  generalities about non adherence to GAAP, but
  much harder to prove specific violations of such
  unwritten rules.

149
So where are we in the process?

• FASB Report, August 31, 2004
• The FASB is addressing objectives-oriented
  standards and addressing deficiencies in the
  conceptual framework.

150
Objectives-Oriented Standards

• Based on an improved and consistently applied
  framework
• Clearly state the accounting objective of the
  standard
• Provide sufficient detail and structure so that
  the standard can be operationlized and applied on
  a consistent basis
• Minimize exceptions from the standard

151

• Avoid use of percentage tests (bright lines)
  that allow financial engineers to achieve
  technical compliance with the standard while
  evading the intent of the standard

152
Conceptual Framework

• The Board agrees that the conceptual framework
  needs to be improved because an internally
  consistent and complete conceptual framework is
  critical to a standard-setting approach that
  places more emphasis on the underlying principles
  that are based on that framework.

153

• The FASB and the IASB agreed in April, 2004 to
  work together to develop a single, complete, and
  internally consistent conceptual framework that
  would be used by both boards.
• The intention is to complete and refine the
  existing framework rather than comprehensively
  reconsider all components of the current
  framework.

154
Format and Content of Standards

• Developing a format for statements that
• Clearly states the accounting objectives
• Clearly articulates the underlying principles
• Improves the explanation of the rationale behind
  those principles and how they relate to the
  conceptual framework.

155
Additional Steps

• GAAP Hierarchy
• Access to Authoritative Literature

156
GAAP Hierarchy

• Creating two levels of literature (authoritative
  and nonauthoritative) and elevating the
  conceptual framework within the generally
  accepted accounting principles (GAAP) hierarchy
  are key elements of the Boards goal of improving
  the quality of the GAAP hierarchy and, therefore,
  the quality and transparency of standards and the
  standard-setting process. The first steps towards
  improving the GAAP hierarchy are to move the
  hierarchy from the auditing literature to FASB
  literature and to expand the sources of category
  (a) to include accounting principles that are
  issued after being subject to the FASBs due
  process.

157

• There is an exposure draft, The Hierarchy of
  Generally Accepted Accounting Principles.
• The comment period ended in June, 2005.
• The Board is moving ahead with the standard and
  will have more information shortly.

158
Access to Authoritative Literature

• Currently developing a single authoritative,
  electronically searchable database that
  integrates and synthesizes all of the U. S.
  accounting literature.

159
And a last reminder of why it is important.

• Arthur Levitt Numbers in the abstract are just
  that -- numbers. But relying on the numbers in a
  financial report are livelihoods, interests and
  ultimately, stories a single mother who works
  two jobs so she can save enough to give her kids
  a good education a father who labored at the
  same company for his entire adult life and now
  just wants to enjoy time with his grandchildren
  a young couple who dreams of starting their own
  business. These are the stories of American
  investors.

160

• For the sake of our markets for the sake of a
  globalized economy which depends so much on the
  reliability of America's financial system for
  the sake of investors and for the sake of a
  larger commitment not only to each other, but to
  ourselves, I ask that we join together to
  reinforce the values that have guided our capital
  markets to unparalleled supremacy. Together,
  through vigilance and trust, I know, we can
  succeed.