PRINCIPLES-BASED APPROACH TO STANDARD SETTING

From FASB newsletter The FASB Report, November 27, 2002

By Linda A. MacDonald, Project Manager
Overview
Recently, many have expressed concerns about the quality and transparency of financial
reporting in the United States. In response, the FASB has issued for public comment a
proposal for a principles-based approach to U.S. standard setting and plans to hold a public
roundtable meeting with respondents to the proposal on December 16. In addition, the
Sarbanes-Oxley Act of 2002 requires the Securities and Exchange Commission (SEC) to
conduct a study on the adoption of a similar approach and to submit the results of that
study to Congress by July 2003.
The Principles
The idea of a principles-based approach to U.S. standard setting is not new. The Boards
conceptual framework contains the body of principles that underlies U.S. accounting and
reporting. The Board has used the conceptual framework in developing the principles in
accounting standards for more than 20 years. However, many assert that the standards have
become increasingly detailed and rules-based (with bright-lines and on-off switches that
focus on the form rather than the substance of transactions), complex, and difficult and
costly to apply. Many also assert that the standards allow financial and accounting
engineering to structure transactions around the rules, referring to situations such as
those in which complex structures or a series of transactions are created to achieve desired
accounting results; for example, to remove assets from the balance sheet while retaining the
overall economics of the assets or to recharacterize assets.
Under a principles-based approach, the principles in accounting standards would continue
to be developed from the conceptual framework, but would apply more broadly than under
existing standards, thereby providing few exceptions to the principles. In addition, the FASB
and other standard-setting bodies would provide less interpretive and implementation
guidance for applying the standards. Because exceptions and interpretive and
implementation guidance are largely demand-driven, a principles-based approach would
require changes in the processes and behaviors not just of the FASB and other standard-
setting bodies, but of all participants in the U.S. financial accounting and reporting process-
including preparers, auditors, the SEC and users of financial information. Significant
changes are discussed below.
Few, if Any, Exceptions
Exceptions in accounting standards create situations in which the principles in the
standards do not apply. Under a principles-based approach, it might not be possible to
eliminate all exceptions. However, the Board believes that an objective of that approach
should be to eliminate exceptions that are intended to achieve desired accounting results
(for example, to limit volatility of reported earnings), which may obscure the underlying
economics of the related transactions and events. To achieve that objective, the Board would
need to resist pressures to provide exceptions in accounting standards. In turn, others
(preparers and users of financial information) would need to accept the consequences of
applying accounting standards with fewer exceptions to the principles, including increased
volatility in reported earnings.
Implementation of Principles-Based Standards
In addition to the FASB, other standard-setting bodies, including the FASB Emerging Issues
Task Force (EITF) and the AICPA Accounting Standards Executive Committee (AcSEC),
provide interpretive and implementation guidance for applying accounting standards. A
principles-based approach would not eliminate the need for interpretive and
implementation guidance. However, the Board believes that an objective of that approach
should be to provide interpretive and implementation guidance that focuses only on
significant matters addressed in the standards, thereby increasing the need to apply
professional judgment in the situations not addressed. In commenting on the proposal,
Robert H. Herz, FASB Chairman, explained, To me, its a matter of where you start, where
you stop and whats your home base. Under a principles-based approach, one starts with
laying out the key objectives of good reporting in the subject area and then provides
guidance explaining the objective and relating it to some common examples. While rules are
sometimes unavoidable and the guidance should be sufficient to enable proper
implementation of the principles, the intent is not to try to provide specific guidance or
rules for every possible situation. Rather, if in doubt, the reader is directed back to the
principles. He added that a principles-based approach, while desirable, would require
participants to exercise good professional judgment and resist the urge to seek specific
answers and rulings on every implementation issue.
To achieve an objective of providing interpretive and implementation guidance that focuses
only on significant matters addressed in the standards, the Board and other standard-
setting bodies would need to resist pressures to provide interpretive and implementation
guidance addressing all possible applications of the standards. In that regard, the Board
would need to establish guidelines sufficient to identify situations in which interpretive and
implementation guidance in accounting standards is appropriate. To ensure that those (or
similar) guidelines are applied consistently after the standards are issued and to improve
consistency in establishment of standards, the FASB is taking the lead in realigning the
structure of U.S. standard setting. Among other things, the FASB is implementing changes
to the roles and processes of the EITF whereby the FASB will have more direct involvement
with the agenda, deliberations and conclusions of the EITF. Also, in collaboration with the
AICPA, the FASB has proposed that AcSEC cease issuing Statements of Position that create
new U.S. GAAP. While the AICPA would continue to issue industry accounting and auditing
guides by way of implementation guidance, the FASB would take on the responsibility for
the standard-setting role filled currently by AcSEC.
In any event, preparers and auditors would need to apply professional judgment in more
situations. In turn, the SEC and users of financial information would need to accept the
consequences of applying professional judgment in more situations, including some
divergence in practice.
The Board believes that an approach focusing more clearly on the principles in accounting
standards is necessary to improve the quality and transparency of U.S. financial
accounting and reporting. Also, a principles-based approach is similar to the approach
used by the International Accounting Standards Board (IASB) in developing International
Financial Reporting Standards (IFRS). Thus, adopting such an approach could facilitate
convergence as the FASB works with the IASB and other national standard setters in
developing common high-quality accounting standards. The Board believes that if all
participants in the U.S. financial accounting and reporting process are willing to make the
changes required under a principles-based approach, the benefits of adopting that
approach would outweigh its costs.