Principles-Based Accounting
It’s Not New, It’s Not the Rule, It’s the Law

By Ronald M. Mano, Matthew Mouritsen, and Ryan Pace

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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 difficult situation.

Law 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.

Continental Vending

Continental 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.

Continental 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.

‘Fairly Presented’

Near 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.”

The 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 rules-based accounting.

One 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 and Sarno.

A central 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 material facts.

Code of Professional Conduct Rule 203

Further 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 Conduct:

A 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.

The 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.

‘Show Me Where It Says I Can’t Do That’

In 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.

The 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.

Related-Party Transactions

The 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 four disclosures:

  • 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.

These 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.

In 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 Standard 6:

  • 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.

These 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.

Condition and Criteria

Internal 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.

To 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.

“Criteria” 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.”

Case Studies

Enron. 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.

Global 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.

To understand how it was able to claim this, remember the equation:

Assets = Liabilities + Owners’ Equity

In 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.

The 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 business.

Acxiom 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.

The 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.

Adhering to the Law Is Overdue

Principles-based 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.


Ronald 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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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