The Future of Accounting Standard Setting

Due to the big time fraudulent scandals that have rocked the corporate accounting profession, the adequacy of the Financial Accounting Standards Board’s (FASB) standard-setting process has been called into question.  Many critics argue that the FASB’s standard-setting process is too focused on developing rules-based standards.  In their textbook titled, Accounting Theory:  Conceptual Issues in a Political and Economic Environment, authors James Dodd, John Rozycki, and Harry Work describe several characterizations of the FASB’s rules-based approach.  According to the authors, “Rules-based standards are highly detailed, often have many exceptions, require extensive implementational guidance, and often have many ‘bright line’ distinctions (e.g., 75% capitalization rules for leases and 50% ownership rules for consolidations)” (pg. 383).  However, the continued progress toward international convergence between the United States’ FASB and the International Accounting Standards Board (IASB) has paved the way for a more principles-based approach to the standard-setting process.

Principles-based standards are believed to be much shorter in nature and possess many fewer exceptions.  However, principles-only standards present enforcement difficulties because they rely heavily on the judgment of either management or the auditing committee when it comes to determining and carrying out the intentions of the standard-setting agency (Wolk pg. 383).  With that being said, extensive implementational guidance is necessary in order for a principles-based approach to work efficiently.  Evidently, the writers of the Sarbanes-Oxley Act had this same idea in mind when creating the influential Act in 2002.  As directed by the Sarbanes-Oxley Act (SOX), the Securities and Exchange Commission (SEC) conducted a study of the FASB’s rules-based standards and the IASB’s principles-based standards and found that both concepts contain many imperfections.  With that being said, the authors of the Accounting Theory textbook state, “The Sarbanes-Oxley Act required the SEC to draft a report on principles-based accounting standards that would better align the interest of management and auditors with investors and creditors” (Wolk pg. 383).  In their mandated report, the SEC offers the following, “To distinguish our vision of a principles-based approach to standard setting from those proposed by others, we refer to it as objectives-oriented standard setting.  Standards established in such a fashion are objectives-oriented in a number of senses” (SEC Report).  This change toward a more objective-oriented standard setting process contains many explicit and underlying strengths, weaknesses, opportunities, and threats; some of which are discussed later in this report.

Objective-oriented accounting standards are when a standard has included enough specificity in the standard where there are few to no misunderstandings on the concepts being addressed. As well, the standard will give enough guidance on how to implement a transaction properly. Lastly, the standard should be consistent, and come from an established financial reporting conceptual framework, so managers and auditors can make sure the reporting captures the transactions accurately.  Objectives-oriented sets forth a situation where management must accurately present the transactions and events in the financial statements.  The SEC believes implementing the objectives-oriented standards will outweigh the costs associated with the implementation. Also, these standards will more closely tie the interests of all stakeholders from management to investors to creditors to auditors.

Objectives-oriented standards will be used in a manner like a combination of the rules-based and principles-only standards best aspects. They will establish,” the objectives and the accounting model for the class of transactions, providing management and auditors with a framework that is sufficiently detailed for the standards to be operational. At the same time, if constructed with the optimal level of detail, such standards would provide users, as well as regulators and others who oversee or monitor the financial reporting process, with sufficient detail to better comprehend and properly gauge the results reported by management and attested to by the auditors.”(SEC Report) Furthermore, the new standards will allow users of financial information to have a deeper understanding of the data they are evaluating by researching a standard’s objective to understand the information it should be conveying.

The steps taken to ensure the objectives-oriented standards will be met are five step process. First, when a standard is being applied, the preparers or auditors must focus on the accounting objective that is at the root of the transaction. Next, a conceptual framework must be the underlying basis of the accounting being done. Third, there can be no room for divergence in standards. Thus, there is a need for more guidance in how transactions are implemented. Fourth, it does not make any definite tests that could be applied to a transaction. Lastly, they will clearly give detailed guidance so a transaction can be appropriately recorded to the area necessary within the accounting system (SEC Report).  The specificity need not be so specific to pigeon hole items, but not broad enough to allow for too much of a diverse interpretation either. This way there will not have to be a voluminous amount of standards available.

The SEC arrived at objectives-oriented standards after an examination of the rules-based and principles-only standards. The rules-based standards lead to inconsistent application many times, because accountants are able to work their way around a rules-based system to arrive at their desired result. A good example of this is the distinction between an operating lease and a capital lease. Many times a company will have a capital lease they are about to sign, but instead will have terms adjusted so they are able to have an operating lease criteria. With the four criteria known that cause a lease to fall into the capital lease realm, companies are able to structure the terms favorably towards operating leases. This is a clear weakness in the rules-based standards, and does not show the true representation of the corporation.

The principles-only standards allow for too much judgment to be introduced by the accountants or auditors who are creating, and auditing financial statements to make sure they represent operations in the same way across industries and companies. The weakness is in the ability to have comparability among financial statements, because one accountant could believe a standard is supposed to be applied in a different manner than another accountant. Both types of standards where created by the FASB over time along with the idea of a conceptual framework.

The Financial Accounting Standards Board (FASB) conceptual framework needs to be defined and established before addressing its deficiencies. The conceptual framework is a “coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements (FASC No.8).”  It is defined through eight statements of financial accounting concepts (SFAC), but their authoritative value is minimal. It is important to note a SFAC does not establish generally accepted accounting standards (Concepts Statements).  The conceptual framework struggles to gain traction in a GAAP rules-based accounting environment. A rules-based environment requires a slow, complex, and detailed approach that attempts to address many different possible scenarios of the same principle accounting issue. Examples of rule-based accounting include derivatives, employee stock options, and leases (Herdman). It falls short in regards to developing an accounting guidance that should strive to reflect the underlying economic substance of the business activity. Given the fact the conceptual framework does not establish generally accepted accounting standards; firm responsiveness to follow the framework in decision making situations is limited.

Industry “opinion is virtually unanimous that SFAC No. 5 on recognition and measurement is the low point of the conceptual framework (Wolk pg. 255).” SFAC No. 5 is sometimes not compatible with the definitions of assets and liabilities expressed in SFAC No. 6. This concept accounts for revenue directly while ignoring how assets and liabilities arise. There are instances where deferred debits and credits come about that do not meet the definitions of assets and liabilities (IASB). The basic form establishes that recognition of an asset received is realized or realizable and that revenue should be earned. In application to liabilities, criteria states expenses and losses arise as the asset is used up or when no further benefits are expected (Wolk pg. 242). There are more than 200 pieces of guidance regarding revenue and gain recognition in the United States alone (IASB). So many rules show a weakness in rules-based standards, and are one of the strengths the objectives-oriented standards should have over rules-based. A rules-based GAAP has resulted in entity specific interests developing recognition criteria that is accepted, but in theory can conflict with other recognition criteria. A stronger conceptual framework could provide guidance to a more objective-based approach to provide financial statement users with relevant and comparable information.

The FASB manages US GAAP, and the IASB manages IFRS. Both the FASB and IFRS are the two boards that govern accounting standards for their respective regions of the United States and the remaining other international countries. The two boards signed a memorandum that is known as the “Norwalk Agreement”. The goal of the converging international accounting standards is to establish a single set of standards that will be used globally. According to the SEC, the boards’ objective is to reduce the differences between US GAAP and IFRS, categorizing differences based upon the most effective strategy for resolving them, and providing input to the board’s agenda setting process as needed to further the goal of convergence.  US GAAP is a rule-based standard and has a more detailed oriented approach than IFRS, which is principles-based standards or objective-oriented standards, therefore, rely on judgment by accountants and auditors when recording transaction (Wolk). Overtime, though not identical, the two standards are expected to parallel, once the objective has been achieved.

However, the work of harmonization between GAAP and IFRS is still in progress and needs improvements.  Harmonization refers to degree of coordination, or similarity among the various sets of national accounting standards and methods and formats of financial reporting (Wolk). One of the main focuses for FASB and IASB toward harmonization is revenue recognition, which is continually mentioned as one of the most principal problems in accounting. Recognizing revenue is critical to users of financial statement in evaluating company’s financial performance. The traditional rules for revenue recognition are an income statement focus, but FASB and IASB are involved in a long-rage project in dealing with revenue recognition. They are in the early stages of viewing revenue recognition in terms of change in assets and liabilities, or a balance sheet approach (Wolk).  An example of this would be the standard regarding revenue recognition when dealing with goods and services to customers. This is a way companies would recognize revenue to depict the transfer of goods and services to customers at an amount that reflects the consideration the entity expects to receive in exchange for those goods or services.  Under US GAAP and IFRS, revenue is not recognized until it is both realized, realizable and earned (US GAAP vs IFRS).  Therefore, both US GAAP and IFRS recognize revenue when risks and rewards of ownership have been transferred.  Despite similarities, there are some differences between IFRS and US GAAP. For instance, on inventory method, US GAAP permits the use of LIFO (last in, first out). US companies use LIFO to lower their current taxable earnings, thereby lower the company’s tax payments, but IFRS prohibits the use of LIFO.

Moreover, the research that was conducted by Altamuro, Beatty, and Weber found “a considerable number of violations of revenue recognitions rules that they connected to earning management” (Wolk).  As a result, the SEC issued Staff Accounting Bulletin (SAB) 101 that provides guidance to firms for applying revenue recognition rules (Wolk). Revenue recognition is one of the most challenging standards for convergence projects. Therefore, FASB and IASB are still currently in process of improvement.  The SEC believe that the “shift by the FASB toward a more objectives-oriented regime should facilitate the convergence process”(SEC Report).

Another step required for implementation of an objectives-oriented approach in financial reporting is redefining the GAAP hierarchy.  According to the SECs Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002, “the current GAAP hierarchy is organized as follows:

 

Authoritative literature:

Level A – FASB’s Statements of Financial Accounting Standards and Interpretations, APB Opinions, and ARBs

Level B – FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides and Statements of Position

Level C – EITF Consensuses and AICPA Practice Bulletins

Level D – AICPA accounting interpretations, FASB staff Q&As, and industry practice

Other literature:

SFACs, AICPA Issues Papers, IASs, textbooks, articles in professional journal.”

(SEC Report)

 

Since the FASB’s conceptual framework is meant to aid the FASB in its deliberations, industry practice is emphasized more than the conceptual framework.  Standard setters should use the conceptual framework as a guide to prepare more specific standards.

The SEC’s study recommends a change in the GAAP hierarchy which would look more like the following:

 

Authoritative literature:

  • FASB conceptual framework documents
  • FASB standards (including SFASs, Interpretations, APB Opinions, ARBs)
  • EITF consensuses… and FSPs

Non-authoritative literature:

  • These could include industry group positions, and positions of knowledgeable professional organizations or entities.”(SEC Report)

 

A drastic change to the GAAP hierarchy would cause some major changes to the accounting profession.  Those changes include adjusting the focus of educational requirements, directing the GAAP hierarchy more toward entities since they are responsible for ultimately selecting the principles used in preparing financial statements (Journal of Accountancy), and altering “the current professional thinking about the importance of the conceptual framework relative to other documents in the literature.”(SEC Report)

As mentioned before, the Sarbanes-Oxley Act of 2002 mandated that the SEC conduct a study of the current standard setting approach  In the Commission’s report, the SEC states, “Principles-only standards may present enforcement difficulties because they provide little guidance or structure for exercising professional judgment by preparers and auditors.  Rules-based standards often provide a vehicle for circumventing the intention of the standard.”  In the executive summary of the agency’s report, the SEC offers the following advice, “The staff recommends that those involved in the standard-setting process more consistently develop standards on a principles-based or objectives-oriented basis.”  In addition, the SEC adds “Such standards should have the following characteristics:

  • Be based on an improved and consistently applied conceptual framework;
  • Clearly state the accounting objective of the standard;
  • Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;
  • Minimize exceptions from the standard;
  • Avoid the use of percentage tests (“bright-lines”) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard” (SEC Report).

Based on the characteristics outlined by the SEC , it is apparent that the use of principles-based or objectives-oriented standards were established in response to the criticisms of the previously used rules-based standards.  As an effect, all of the criticisms of rules-based standards can be seen as strengths of objectives-oriented standards. According to the SEC’s report, “Objectives-oriented standards clearly articulate the class of transactions to which they apply and contain sufficiently-detailed guidance so that preparers and auditors have a structure in which to determine the appropriate accounting for the company’s transactions.”  In addition, the SEC believes that “in applying a particular standard in practice, preparers (and auditors) are required to focus the accounting (and attestation) decisions on fulfilling the accounting objective of that standard.  This minimizes the opportunities for financial engineering designed to evade the intent of the standard” (SEC Report).

Although the SEC engineered objectives-oriented standards to “contain sufficiently-detailed guidance so that preparers and auditors have a structure in which to determine the appropriate accounting for the company’s transactions,”(SEC Reprot) not every possible situation or contingency can be covered by any sort of standard.  With that being said, objectives-oriented standards will still require at least some use of judgment by accountants and auditors.

In addition, the authors of the Accounting Theory textbook also mention that, “Critics have pointed out that the objectives are obvious and do not specify operational objectives that can be put into practice” (Wolk pg. 203).  The authors largely discredit this criticism and believe that objectives-oriented standards represent an important step taken toward establishing a meaningful conceptual framework of accounting objectives (Wolk pg. 203).

The trend toward an objectives-oriented standard setting approach presents two major opportunities that may significantly increase the comparability among the accounting profession.  First of all, objectives are highly useful when drafting and establishing a universal conceptual framework.  With that being said, the approach towards more objective-oriented standards may significantly improve the efficiency of conceptual frameworks in the accounting profession.  Conceptual frameworks are constantly used in the accounting profession to provide guidance and an assessment of accounting standards and practices to accountants, auditors, and management.  The SEC apparently identified the same opportunity.  According to the Commission’s report, the objectives-oriented standard setting approach would “clearly establish the objectives and the accounting model for the class of transactions, providing management and auditors with a framework that is sufficiently detailed for the standards to be operational.”(Second time this is in the paper. We have used the same quotes multiple times throughout the paper)  In addition, the SEC believes that “because objectives-oriented standards provide a better framework in which to exercise professional judgment than do either rules-based or principles-only standards, they may serve to better facilitate compliance with the intent of the standards” (SEC Report).

In addition to improving the conceptual frameworks used in the United States, the use of objectives-oriented accounting standards may increase the comparability of the accounting profession internationally.  International convergence has been a main issue and increasing trend in the recent years.  Now that the FASB has developed the use of objectives-oriented standards, which is considered true principles-based approach, one less difference exists among the FASB and IASB.  This presents a huge opportunity to increase the sense of comparability among countries internationally.  According to the SEC’s mandated report, “Standard setters can come to an agreement on a principle more rapidly than they can on a highly detailed rule. The benefits of convergence include greater comparability and improved capital formation globally.”  With that being said, the SEC sees “convergence as a process of continuing discovery and opportunity to learn by both U.S. and international standard setters” (SEC Report).

As identified before, no standard setting approach will be able to cover every possible situation and contingency that exists.  With that being said, authors Dodd, Rozycki, and Wolk identify a possible threat regarding the amount of detailed guidance included in the objectives-oriented standards.  In their Accounting Theory text, the authors express their belief that there is a “gray area between providing enough detail to allow a standard to be operationalized and providing sufficient information to cover virtually every contingency.  Before the line of too much detail is crossed, judgment comes into play.  Finding this happy medium is not easy” (Wolk pg. 383).  In addition, the authors state, “when judgment comes into play we enter the arena of potential moral turpitude, a situation that accountants increasingly experience” (Wolk pg. 383).

The rules and standards of the accounting profession will undoubtedly continue to change.  And there will always be some accountants who can figure out ways to circumvent the rules.  The best thing that regulators and the members of the accounting profession can do is to continue to improve the standard setting process in order to find that happy medium. It appears the development of an objectives-oriented standards approach would help the accounting profession to establish more trust to the financial statement users, then those standards of rules-based and principle-only standards. With the continued push towards convergence by the FASB and IASB the objectives-oriented standards will be familiar to users worldwide, and will make comparability of statements easier on across the world. Hopefully, these standards will continue to develop and allow the accounting profession to reach new highs in respect after such lows in the early parts of the first century.

 

 

Works Cited

 

 

Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. Rep. Securities and Exchange Commission. Web. 13 Oct. 2013.

 

FASB issued Statement no. 162, The Hierarchy of Generally Accepted     Accounting Principles. Journal of Public Accountancy. Highlights, July 2008. Web.

 

Wolk, Harry I., James L. Dodd, and John J. Rozycki. Accounting Theory: Conceptual Issues in a Political and Economic Environment. 8th ed. Thousand Oaks: SAGE Publications, 2013. Print.

 

HYPERLINK “http://www.ey.com/Publication/vwLUAssets/US_GAAP_versus_IFRS” http://www.ey.com/Publication/vwLUAssets/US_GAAP_versus_IFRS

“Concepts Statements.” FASB.org. FASB. Web. 14 Oct 2013. <http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156317989>.

 

Herdman, Robert . “The Roles of the SEC and the FASB in Establishing GAAP.” U.S. Securities and Exchange Commission. N.p., 14 May 2002. Web. 17 Oct 2013.

 

International Accounting Standards Board (2007a). Revenue Recognition-Information for

Observers (Agenda papers 4A, 4B, 4C, 4D, 4E, 4F, 4G). London, UK: IASB.