Not New, It’s Not the Rule, It’s the Law
Ronald M. Mano, Matthew Mouritsen, and Ryan Pace
FEBRUARY 2006 - There
is currently an intense debate over the merits of rules-based
accounting versus principles-based accounting. In the opinions
of these authors, the debate is a waste of time, because for
at least 35 years, the law has required adherence to principles-based
accounting. The fact that practitioners have ignored the law
is one reason for the accounting profession’s current
comes into existence not only through legislation, but also
by regulation and litigation. Laws from all three sources
are binding, one source no less so than another. The authors
conclude that a 1969 criminal court case commonly known
as Continental Vending made “principles-based
accounting” the law. Therefore, principles-based accounting
is not new, and it is not just a rule; it is the law. In
which case the time is long past when accountants should
adhere to principles-based accounting.
Vending [U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969)]
was one of the first major criminal cases successfully brought
against auditors. Charges against the auditors involved
in the case included the violation of U.S. securities laws
by certifying a document the auditors knew to be false.
The auditors were engaged to audit Continental Vending Machine
Corporation. A Continental affiliate, Valley Commercial
Corporation, borrowed a large sum of money from Continental.
Valley then loaned the funds to a dominant officer and significant
shareholder of both Valley and Continental. The auditors
learned that the dominant officer would not be able to repay
Valley, and the auditors knew that as a consequence Valley
would be unable to repay Continental. Nevertheless, the
Continental financial statements showed the receivable from
Valley as an asset, with only a relatively obscure footnote
explaining the circumstances surrounding the receivable.
never did collect payments from Valley on the receivable
in question; in fact, Continental went bankrupt shortly
after the financial statements were issued. When the U.S.
government brought criminal charges against the auditors,
the auditors maintained that they properly followed generally
accepted auditing standards (GAAS) during the audit and
that the footnote also complied with applicable standards.
Moreover, several experts testified that the footnote disclosure
explaining the receivable from Valley complied with generally
accepted accounting principles (GAAP) and that the auditors
had followed GAAS.
the end of the trial, the district court judge instructed
the jury that mere compliance with professional accounting
standards was not a complete defense. Rather, the critical
test was whether the financial statements fairly represented
Continental’s financial status. The jury found the
defendants guilty. On appeal, the appellate court held that
the district court judge did not err in his instructions
to the jury. As Professor Robert R. Sterling stated in a
January 1973 Journal of Accountancy article: “[T]
he courts are telling us that we can no longer defend ourselves
on the basis of accepted accounting theory and practice.
Instead, we must assure ourselves that the statements are
true, correct and understandable to non-accountants.”
appellate court judge in Continental Vending, in
refusing to find error in the district court’s jury
instructions, clearly told the accounting profession that
“fairly presented … in accordance with generally
accepted accounting principles” is two statements
rather than one. Furthermore, the clear message was that
if one is to prevail over the other, it must be “fairly
presented.” “Fairly presented” is principles-based
accounting, and “in accordance with GAAP” is
way that court decisions effectively become part of law
is by being cited by other courts in future cases. Numerous
subsequent cases have favorably cited Continental Vending,
including the Second and Ninth Circuit cases of Natelli
issue in Continental Vending was whether the auditors
could defend themselves by demonstrating compliance with
GAAS and demonstrating that the financial statements were
in accordance with GAAP. The court held that even if the
auditors could prove that they had complied with GAAS and
that the financial statements were prepared in accordance
with GAAP, this would not be a complete defense to the criminal
charge of willfully and knowingly making a false statement.
The decision clearly illustrates that the auditor must make
sure that the financial statements adequately disclose known
of Professional Conduct Rule 203
evidence that accountants must ensure that financial statements
are fairly presented, regardless of whether they conform
to GAAP, can be found in Rule 203 of the Code of Professional
member shall not (1) express an opinion or state affirmatively
that the financial statements or other financial data
of any entity are presented in conformity with generally
accepted accounting principles or (2) state that he or
she is not aware of any material modification that should
be made to such statement or data in order for them to
be in conformity with generally accepted accounting principles,
if such statements or data contain any departure from
an accounting principle promulgated by bodies designed
by Council to establish such principles that have a material
effect on the statements or data taken as a whole. If,
however, the statements or data would otherwise have been
misleading, the member can comply with the rule by describing
the departure, its approximate effects, if practicable,
and the reasons why compliance with the principle would
result in a misleading statement.
last sentence is critical. It requires accountants to depart
from GAAP if compliance with the rules would make the financial
statements misleading. Therefore, it seems that accounting
ethics also require principles-based rather than rules-based
accounting. Unfortunately, the accounting profession seems
to have been ignoring the last sentence of Rule 203 just
as it has ignored the lessons that should have been learned
from Continental Vending. Three recent specific
examples (Enron, Global Crossing, and Acxiom) will be discussed
later in this article.
Me Where It Says I Can’t Do That’
April 2003, PricewaterhouseCoopers placed a full-page advertisement
in the Wall Street Journal. The advertisement—actually
more of a statement of the firm’s support of principles-based
accounting—said: “Rules-based systems encourage
creativity (and not the good kind) in financial reporting.
They allow some to stretch the limits of what is permissible
under the law, even though it may not be ethically or morally
acceptable. A principles-based system requires companies
to report and auditors to audit the substance or business
purpose of transactions; not merely whether they can qualify
as acceptable under incredibly complex or overly technical
rules.” It went on to say: “A rules-based system
allows managers to ignore the substance and, instead ask,
‘Where in the rules does it say I can’t do this?’”
It appears that, even after more than three decades, PricewaterhouseCoopers
has not forgotten about Continental Vending.
authors are reminded of a speaker at the Federation of Schools
of Accountancy conference in Denver in October 2003. Mark
Terrell, a former audit partner at KPMG, stated that he
decided he had to get out of auditing because if he did
not he would be going to jail. He said that he would be
going to jail not because of falsified financial statements,
but rather for murder. He explained that he had to get out
of auditing because if he ever had another client say, “Show
me in the rules where it says I can’t do that,”
he was going to kill him.
accounting profession’s response to the lesson that
it should have learned from Continental Vending
missed the point. Rather than recognize how critical principles-based
accounting had just become to the profession, through a
convoluted approach it created yet another rule to deal
with the issues of Continental Vending. In July
1975 (six years after the Continental Vending decision
and 13 years after the issuance of the misleading financial
statements), the AICPA, through its Auditing Standards Executive
Committee, issued Auditing Standard 6, titled “Related
Party Transactions.” That standard required the following
The nature of the relationship;
A description of the transactions for the period, including
amounts, if any, and such other information as deemed
necessary to understand the effects on the financial statements;
The dollar volume of transactions and the effects of any
change in the method of establishing terms from that used
in the preceding period; and
Amounts due from or to related parties and, if not otherwise
apparent, the terms and manner of settlement.
requirements are disclosure standards issued by the Auditing
Standards Board (ASB). During the interim between 1969,
when the Continental Vending decision was rendered,
and 1975, when Auditing Standard 6 was issued, FASB came
into existence, replacing the Accounting Principles Board
(APB). FASB was charged with issuing accounting standards.
Disclosure standards are accounting standards, not auditing
standards. What was the ASB doing issuing accounting standards?
Apparently the AICPA thought accounting standards were needed
to guide accountants that might be faced with issues similar
to those faced by the auditors of Continental Vending.
1982, seven years after the ASB issued its accounting standard,
FASB issued SFAS 57, Related Party Transactions.
In that standard, FASB required four specific disclosures
very similar to the four disclosures required by Auditing
The nature of the relationships involved;
A description of the transactions, including transactions
to which no amounts or nominal amounts were ascribed,
for each of the periods for which income statements are
presented, and such other information deemed necessary
to an understanding of the effects of the transactions
on the financial statements;
The dollar amounts of transactions for each of the periods
for which income statements are presented, and the effects
of any change in the method of establishing the terms
from that used in the preceding period; and
Amounts due from or to related parties as of the date
of each balance sheet presented and, if not otherwise
apparent, the terms and manner of settlement.
requirements are so nearly identical to those of the auditing
standards that the current volume of auditing standards
no longer lists the four requirements, it simply refers
the reader to SFAS 57.
auditors use what they call “condition” and
“criteria.” Condition is the current situation:
what actually exists. Criteria is what the ideal situation
would be. The internal auditor must determine what to use
as criteria. This is done by a careful analysis of the business
situation based on the internal auditor’s experience
and knowledge. There is no rulebook for the internal auditor
to use. Each situation is different and demands different
analytical skills. The auditor must decide on the best practice.
determine criteria, the external auditor turns to GAAP.
The external auditor applies those rules, and if the company’s
practice can be “squeezed” into the confines
of GAAP, the external auditor declares that the practice
is “fairly presented in accordance with GAAP.”
The external auditor might not agree with the presentation
yet support it because it fits within the rules. There is
no commitment to the rule for the external auditor as there
must be a commitment to criteria for the internal auditor.
As Professor Sterling stated in the aforementioned article,
an external auditor is unwilling to accuse the client of
telling a lie even if he might believe that it is not truthful
accounting. Because an Andersen auditor did not have to
accuse a client of breaking a rule, and was apparently unwilling
to accuse him of telling a lie, the profession is now dogged
by the Enron debacle.
in internal auditing would be principles-based accounting.
“Criteria” in external auditing would be rule-based
accounting. It seems clear that the profession needs principles-based
accounting today. It needs external auditors to take some
ownership in the criteria that they apply when they profess
that the financial statements are “fairly presented.”
In the well-documented case of Enron, the
company was able to hide vast amounts of debt through the
use of special purpose entities (SPE). CFO Andy Fastow seemed
to be an expert in the specifics of the accounting standards
relating to the accounting for SPEs. Unfortunately, he apparently
used that knowledge to convince the auditors that what he
was doing was comfortably within the rules and that they
should therefore issue an unqualified auditors’ opinion.
In some cases, apparently, his interpretation of the rules
may have been in a gray area, but it appears that Fastow
was able to convince the auditors that application of Rule
203 or the lessons that should have been learned from Continental
Vending did not apply to Enron’s situation.
Crossing. On March 11, 2004, the Wall
Street Journal reported that Global Crossing had just
reported a quarterly profit of $24.88 billion, which dwarfed
the prior record of $6.7 billion, held by Exxon for its
fourth quarter of 2003. Global Crossing had been under Chapter
11 bankruptcy protection. It managed to turn things around
quickly on revenue of $719 million, or $34.60 of profit
on every $1 of revenue—a fantastic profit margin.
And that is a net-profit margin, not a gross-profit margin.
understand how it was able to claim this, remember the equation:
= Liabilities + Owners’ Equity
bankruptcy, the liabilities are forgiven. Therefore, to
keep the equation in balance, either assets must go down
or owners’ equity—stock, retained earnings,
revenues, expenses, and gains and losses—must go up.
Global Crossing chose to increase owners’ equity by
increasing “gains.” Without being privy to internal
discussions, one might still reasonably assume that the
company accountants challenged the auditors to show them
“where in the rules” it says that they could
not do that. In fact, the rules do recommend that liabilities
forgiven in bankruptcy be handled in exactly this manner.
authors believe that both the in-house accountants and the
auditors of Global Crossing would have been well served
had they gone back and studied the statements made by the
appellate court in Continental Vending. The application
of Rule 203, the definition of “criteria” as
used in internal auditing, and the lessons of Continental
Vending would have clearly indicated that a better
reporting approach would have been to take these gains directly
to retained earnings rather than through earnings, and avoid
a situation where a bankrupt company reports the highest
quarterly profit (by fourfold) in the history of American
Corporation. A November 23, 2004, Wall Street Journal
article, “Loophole May Ease Pain of Expensing
Option,” discussed a maneuver devised by Acxiom Corporation
involving the requirements of a pending rule relating to
stock options. The move would allow Acxiom to shift future
expenses onto the current year’s financial statements,
where stock-option expenses can be relegated to mere footnote
disclosures and excluded from net income. The article stated
that Acxiom’s treasurer, Bob Bloom, readily acknowledged
that the company’s primary reason for accelerating
the vesting dates was to “reduce the impact of the
upcoming FASB pronouncement.” The article then reported
Bloom saying that “he doesn’t see anything wrong
with that.” Presumably, Bloom was saying that it was
completely within the rules of GAAP. The authors would encourage
Bloom to carefully review the message sent by the court
in Continental Vending, and Rule 203 of the Code
of Professional Conduct.
authors agree with Glass Lewis & Company analyst Todd
Fernandez, whom the same Wall Street Journal quoted
as saying, “Acxiom’s move to accelerate the
vesting dates for options that were almost in the money
sends the wrong signal and isn’t in the best interest
of transparency and earnings quality.” The authors
would hope that the auditors of Acxiom will stand up and
require full and clear disclosure of this earnings manipulation.
to the Law Is Overdue
accounting is not new, it is not just a rule, it is the
law. It is past time that all accountants subscribe to and
adhere to the law. That means that we must make sure that
all financial statements are high quality and totally transparent.
Otherwise, auditors and in-house accountants alike will
continue to find themselves the subjects of criminal prosecution,
as did the auditors of Continental Vending and the accountants
of Enron and HealthSouth.
M. Mano, PhD, CFE, CPA, is a professor, Matthew
Mouritsen, PhD, is an assistant professor, and Ryan
Pace, JD, LLM, is an assistant professor, all at
Weber State University, Ogden, Utah.