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One area ready for the shift to a principles-based standard is that of the basis for consolidation. The majority of Fortune 500 companies present consolidated financial statements; therefore, any change in accounting for consolidations will have a wide impact.

The FASB proposed a change in the determination of control for the purposes of consolidation in 1999. The proposed definition focuses on economic substance and requires consolidation whenever there is “effective” control rather than legal control. Although this definition has gained little support to date, it is a good example of a principles-based standard. Comparing the rules-based definition of control to the proposed principles-based definition provides insight into the issues that may arise when adopting a principles-based system.

Rules-Based Approach to Accounting Standards

Financial statement preparers, management, and auditors want precise “rules” that unambiguously specify the accounting for a transaction. Exhibit 1 summarizes the benefits and criticisms of a rules-based approach. The major criticism—that, no matter how technically detailed, there is a way around every rule—underscores the extent of the problem faced by accountant or auditor challenged with, “Show me the rule that says I cannot do this.” Consequently, even if a transaction circumvents the spirit of the standard, it is difficult for the accountant or auditor to argue that the standard itself is violated. Perhaps equally troubling is the situation where the auditor applies individual accounting rules and does not step back and consider whether the reported results actually reflect the big picture.

Accounting standards that are developed under a rules-based approach must be continuously updated. Whenever a new transaction is engineered, or a variation of an existing transaction occurs, guidance or a new amendment must be added. Therefore, a rules-based approach is always at least one step behind. The detailed level of interpretative guidance, amendments to existing guidance, and rulings issued by various bodies add to the complexity and have caused a rules explosion. As business processes have become more complex, accounting rules have rapidly changed and expanded. Many standards are so complex that their application, implementation, and implications require explanation. Rules-based GAAP has become more complicated because of the numerous exceptions woven into the standards. These exceptions make applying a standard to a given transaction even more difficult.

Principles-Based Approach

Principles-based standards use broad guidelines that focus on the spirit of an underlying principle. The standards are based on underlying principles with the application and implementation in the hands of the preparers. Exhibit 2 presents the benefits and risks of adopting a principles-based standard system.

The most compelling argument for a principles-based system is that of presenting substance over form. Application of a principles-based approach would focus on the intent of the principle rather than the bright-line rule, thereby reducing the gamesmanship of circumventing the rules. Another benefit of a principles-based system is reduced complexity. Principles-based standards would not require detailed guidance to deal with increasingly complex transactions. Accordingly, a principles-based system requires professional judgment. Many argue that the application of professional judgment is what determines fair presentation in a particular case, not rules for all possible circumstances.

When business practices and technology evolve in a principles-based system, preparers can focus on applying the core principles rather than searching for or demanding specific guidance. More important, a principles-based approach focuses financial statement preparers and auditors on the fairness of the overall financial presentation rather than on satisfying detailed provisions.

Over the past several years, FASB has worked with the International Accounting Standards Board (IASB) on converging U.S. GAAP with International Accounting Standards (IAS), which are generally less detailed than many SFASs. If the European Union adopts IAS on its scheduled 2005 deadline, the IAS principles-based standards will have increasing international acceptance. A shift of U.S. GAAP toward principles-based standards could simplify the international convergence process.

Concern that a principles-based system creates even greater potential for fraud is a powerful counterargument. Some fear that if financial statement preparers and auditors feel unconstrained by clearly defined rules, they are unlikely to follow even broader principles. Both rules-based and principles-based standards, however, are effective only when rigorously applied. Neither principles nor rules will prevent fraud. We have no way of knowing if principles-based accounting would have stopped the recent accounting debacles.

Opponents argue that a principles-based system will require the SEC to spend considerably more time in enforcement and that evaluating accounting decisions made in good faith will be difficult. As a consequence, de facto rules may form in the absence of adequate guidance, thereby defeating the purpose of a principles-based system. The considerable judgment that a principles-based system requires invokes another significant concern: legal liability. Both auditors and managers could be exposed to litigation despite good-faith application of the principles. Many also argue that principles-based standards will reduce comparability, because different outcomes are bound to occur when different individuals apply professional judgment to the same situation.

Many investors find it difficult to understand the financial information presented in a corporation’s annual report. Some argue that this is due not to the complexity of the rules, but to the complexity of business models in the marketplace. While using a principles-based system might improve reporting the economic substance of a transaction, eliminating rules may not make the financial information more understandable.

Applying a Principles-Based Definition of Control

Consolidated financial statements are critical to the evaluation of the economic entity. Control is the criterion for consolidation, and the debate is over how to define control. Since 1959, control has meant either direct or indirect ownership of more than half of the outstanding voting shares of another company’s stock, unless the control is determined to be temporary (ARB 51, 1959). The Enron debacle demonstrates the need for a principles-based definition of control; Enron did not consolidate hundreds of off-balance-sheet entities and therefore failed to recognize the associated liabilities. The irony is that even though Enron violated the core principles of financial reporting, the financial engineering complied with the rules.

In 1999, FASB issued an exposure draft that proposed a principles-based definition of control. “Exposure Draft (Revised), Proposed Statement of Financial Accounting Standards, Consolidated Financial Statements: Purpose and Policy” (October 16, 1999) stated the following:

Control is the ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities. For purposes of consolidated financial statements, control involves decision making ability that is not shared with others.

When a company has “exclusive power” over another entity, it can “direct the use of and access to another entity’s assets.” This would generally be true when a company has the power to set policies that guide how subsidiaries’ assets are used in ongoing activities.

This definition would apply to the control of entities other than corporations, such as partnerships and joint ventures. It would also include control by a minority shareholder as long as that person has nonshared decision-making ability to guide the activities of the subsidiary. Applying the principle underlying this definition of control requires ascertaining which entity is the decision-maker. In many instances this will require assumptions about the entity in control and the entities not in control.

For example, if a minority shareholder is determined to be the one that has nonshared decision-making, and therefore control, then it is necessary to assume that another holder (or the majority holder) will not step in and overpower that controlling holder. Possibly, however, the majority holder is happy with the decisions made by the minority shareholder and therefore is silent. If the majority shareholder were not satisfied, it could usurp power and take over the decision making. The principles-based definition essentially requires the assumption that another holder will not exercise its majority ownership rights. This scenario illustrates the professional judgment required under a principles-based system.

The use of convertible preferred stock, stock options, redeemable instruments, and convertible bonds must also be addressed. Some observers have pointed out that these instruments are taken into consideration for purposes of determining control. To do so would be consistent with how accounting principles (presumably) treat convertible instruments when calculating fully diluted earnings per share (EPS); however, currently, convertible instruments are not taken into consideration when determining ownership interest. If these instruments are taken into consideration, assumptions must be made regarding the probability that the nonactive but potential majority owner will actually exercise the conversion rights and also exercise control by making decisions.

Additional assumptions would be needed if the conversion were mandatory. The holder of a convertible instrument may not hold it until the date of mandatory conversion. Is one to assume the convertible instrument is always held to maturity? That assumption may be complicated if a conversion has a benefit that would be too great to forfeit. Clearly, a principles-based definition of control requires evaluating the holder’s intentions.

Unanswered Questions

Many questions remain unanswered regarding the implementation of a principles-based system, and the above discussion describes just a few as applied to the definition of control. Whether principles-based standards will result in a system with better transparency, understandability, and comparability overall probably has no clear answer at present. Advocates believe that, over time, the principles-based approach will lead to better reporting of financial information. Opponents believe the subjective nature of a principles-based system will reduce comparability.

A revised definition of control for purposes of consolidation is needed. Although majority ownership may be an indicator of control, Enron has demonstrated that there are other ways to garner the risks and rewards of another entity without a majority holding. In addition, control cannot always be objectively measured. Perhaps a principles-based definition is a better way to capture the essence of control. The question remains: Is it possible to make the judgments and accept the uncertainty needed to determine control in principle?