On Principles-Based Accounting and Continental Vending

Responding to “Principles-Based Accounting and the Continental Vending Decision” (Inbox, July 2006), Ronald J. Murray missed the mark in his response to principles-based accounting and the Continental Vending case decision discussed by professors Ron Mano, Matthew Mouritsen, and Ryan Pace in the February 2006 issue. As a criminal defense trial attorney and licensed CPA, I will attempt to address some of Murray’s concerns and address other issues that may assist readers in understanding how legal proceedings unfold.

The Supreme Court and binding legal authority. Murray argues that “the decisions of one circuit court are not binding on others unless the Supreme Court has affirmed the decision.” First of all, the fact that the U.S. Supreme Court has not affirmed a decision does not mean it is not law. The Supreme Court has the discretion of hearing a case if it believes there is a constitutional question to be decided. That is not the case in Continental Vending. Thus, the law in Continental is binding. Furthermore, other courts that are outside of Continental’s jurisdiction are not obligated to follow the ruling in Continental; however, they are not precluded from following the decision in Continental as it applies to similar cases that are pending. Courts all over the United States look outside of their particular jurisdiction for guidance on cases that have new circumstances that have not been decided before.

In my own research, I found cases outside of the Second Circuit, where Continental was decided, that cited Continental as law. These other circuits include the Third, Sixth, Seventh, and Ninth. Although the reasons for citing Continental varied, cases outside of a particular jurisdiction do carry weight.

Continental’s presiding judge’s opinion of acquittal. Murray argues that “the judge … would have acquitted the defendants.” The fact that the judge would have acquitted the defendants is without legal merit. Under criminal law, if the prosecutor has not proved its case in chief beyond a reasonable doubt, the judge, even after the jury has found a defendant guilty, can overturn the decision. This is especially true if there are points of law—in this case the jury instructions—that the lay jury may have incorrectly applied to a set of facts. The trial judge does not have to wait for an appeal to overturn a decision he believes should be overturned immediately.

As a former prosecutor who has tried dozens of jury trials, I had a case overturned by a judge when the jury found the defendant guilty. A trial judge does not have to wait for a reversal of the jury’s decision by an appellate court to apply justice. The trial judge has wide discretion, and the fact that he chose not to overturn the decision is not evidence of an incorrect decision by the jury or the appellate court.

Jury trials versus bench trials: It’s the defendant’s decision. Murray argues that the “judge … would have acquitted the defendants if he [the presiding judge] had been the trier of the facts; that is, if there was no jury.” The defendants had an option of who they wanted as a fact-finder: the judge or jury. When a judge decides the fate of a defendant, it is referred to as a bench trial. Although the U.S. Constitution guarantees defendants the right to a jury trial, the right lays with the defendant, not the prosecution. When defendants decide to waive their right to a jury trial, they do so for strategic reasons. Just as it is a strategic decision to have a jury decide a case, it is a strategic decision to have a bench trial.

I am very skeptical of Murray’s position that the judge would have acquitted the defendants. If that were the case, any competent defense lawyer would have advised his client to waive his right to a jury and take their chances with a judge. My experience has been that although judges do not tell either side what they would do in a given case, because they do not have all the facts, if the judge was this blatant in his opinion as Murray argues, Continental’s presiding judge would have given subtle cues as to how he would rule in a bench trial.

Last, the appellate court has the option of overturning a jury’s verdict if the court believes that the case was not proved beyond a reasonable doubt. One needs to keep in mind that in this case the jury believed the prosecution proved the case beyond a reasonable doubt, and so did the appellate court.

Expert witnesses. Murray argues that “while the accounting experts thought that the footnote disclosures were adequate, the lay jury did not.” Accounting experts are just that: experts. Experts apply their specialty to a specific set of facts, but they cannot testify as to a legal conclusion, such as whether the defendants are guilty or not guilty. To decide guilt or innocence is not their prerogative; it is the jury’s. If all that was needed was an expert to come and testify to what a paying client wants them to say, trial participation would be moot. Parading dozens of experts before a jury does not make one side or the other more credible. If we followed Murray’s reasoning, then trials are basically a wonderful place for experts to create god-like perceptions because they are experts, and how dare a lay person question the opinion of an expert.

Auditor burdens. The opinion in Continental should not be ignored. Post-Enron, WorldCom, and other organizational meltdowns, the application of principles-based accounting has received increased attention. Moreover, viewing principles-based accounting as a theoretical accounting principle to apply at one’s convenience is a risk that could potentially expose a CPA to criminal prosecution. Simply applying GAAP is not enough; CPAs must be cognizant that the law does consider whether they incorporated the principles-based standard when necessary.

The court in Continental went on to state that an auditor’s certification that addresses financial statements that “fairly present” and are “in accordance with generally accepted accounting principles” are two separate statements, thus two separate burdens auditors incur. The fact that the auditors may have correctly applied GAAP does not mean that the financial statements are fairly presented. In essence the court is applying principles-based accounting to its legal reasoning. Following GAAP and making sure that the financial statements fairly present the financial status of the organization are not mutually exclusive.

The court has placed the auditor on notice that being “rules-based” is insufficient to avoid criminal liability; the auditor must also apply “principles-based accounting” when appropriate in order to ensure that the financial statements fairly present the financial status of an organization. Preparing financial statements in accordance with GAAS and GAAP is not a complete defense, especially when material information is not disclosed.

Continental’s legal reasoning. As the court went on to state in Continental, “[g]enerally accepted accounting principles instruct an accountant what to do in the usual case where he has no reason to doubt that the affairs of the corporation are being honestly conducted. Once he has reason to believe … this basic assumption to be false, an entirely different situation confronts him.” The court went on to state that if the basic assumption is in doubt, the accountant must extend auditing procedures to determine whether or not suspicions are justified, and if they are justified, either the wrong is corrected or full disclosure is necessary. If certification means that accountants have no responsibility to reveal known dishonesty, reliance placed on an auditor’s report “would mean nothing and the reliance placed on it by the public would be a snare and a delusion.” It should be clear that the court is basically advancing the proposition in its legal opinion that “in accordance with generally accepted accounting principles” is rules-based accounting and “fairly presented” is principles-based accounting.

The Continental ruling clearly states that attempting to justify transactions under complex accounting rules while ignoring whether the statements are “fairly presented” will not be readily accepted by the courts as a viable defense. When attempting to ignore principles-based accounting and apply a more rules-based accounting approach, a more legalistic approach to auditing inevitably ensues, one which implies that if no rule exists, the transactions can be reported in a certain manner even if there is no intuitive, logical outcome to the applied method of reporting.

The Ninth Circuit, in U.S. v. West [407 Fed.Supp 1148, 1159 (9th Cir. Nebraska, 1976)], cited Continental: “The Second Circuit painstakingly reviewed the criminal liability incurred through improper accounting of receivables. The test is whether the financial statements as a whole present the financial position of the company. If they do not, the basic issue becomes whether the defendants acted in good faith. Proof of ‘good accounting practices’ while it may be highly persuasive is not conclusive in resolving the question of good faith.” The well-known legal scholar Judge Richard A. Posner of the Seventh Circuit, in In Re. EDC [930 F.2d 1275 (7th Cir. Illinois, 1991)], cited Continental, saying the government’s “burden was not to show that defendants were wicked men with designs [on] anyone’s purse … but that they had certified a statement knowing it to be false.”

Enron for consideration. The auditors, accounting experts, and lawyers for Enron were creative enough to find a way to justify Enron’s reporting in such a way that complied with GAAP and appeased CFO Andrew Fastow, who projected an image of being an “expert” on special-purpose entities (SPE). Enron, with the application of SPEs, successfully hid losses and considerable debt from investors. Yet, under Continental’s reasoning, the two-pronged test would have failed. Although the rules-based accounting approach justified Enron’s GAAP application, the financial statements did not fairly present Enron’s financial status because principles-based standards were not applied to the second prong of the test.

The fact that the auditors could point to a rule to justify a position is not enough, because the law states that rules-based accounting and principles-based accounting are not mutually exclusive, but must be considered together when necessary. Clearly the lawyers and auditors for Enron failed to consider the opinion in Continental.

A continuing debate. Although CPAs should ask whether an accounting approach is legal, we should also be asking whether the approach is right, intuitive, logical, and assists the users of the information. By applying only a rules-based accounting approach, a legalistic mind-set develops, compromising the integrity of the profession the way it was compromised in Enron and other organizations. Although it is reasonable to debate what principles-based accounting entails, in the end the accounting profession is better served by having the debate than by not having the debate. However, the debate should not revolve around whether principles-based accounting is rooted in the law because Continental has shown that it is the law, and it carries serious consequences if ignored.

The author responds:

Before commenting on the letter, which contains an important factual error, I should give some brief background on the original article and my letter, each of which originally appeared more than a year ago.

The fine article by professors Mano, Mouritsen, and Pace reminded us of the principle established by the Continental Vending case: It is not enough for financial statements to comply with generally accepted accounting principles. Rather, they should also constitute a fair presentation. My letter, which was not written as a legal analysis, acknowledges this conclusion. It was intended to give more background on the case and to point out that many knowledgeable observers at the time believed the case was wrongly decided—that is, that the defendants committed no crime. The observers’ conclusion was based on the fair presentation principle established by the case, not merely a rules-based approach. In the interests of complete disclosure, as mentioned in my original letter, I am retired from the firm that audited Continental Vending and I was well-acquainted with the three defendants, each of whom was an honorable, upstanding person.

The important factual error appears under Jury trials versus bench trials: It’s the defendant’s decision. In fact, the defendants wanted the case to be decided by a judge because they were concerned that a lay jury would not understand the case. The prosecution (for its own reasons) insisted on a jury trial, and its position was upheld on appeal. As the case unfortunately turned out, the defendants’ concerns proved to be well-founded. Among other things, some of the jurors fell asleep during the proceedings. Apparently accounting cases are not very interesting to laymen.

The letter writer mentions in two places that “Murray argues that the judge would have acquitted the defendants.” The second time he also says that he is very skeptical about my “position.” It is not a question of my “argument” or my “position.” It is a fact. At the sentencing of the defendants, which I attended (I don’t know if Perri was there), the judge stated clearly that he would have acquitted the defendants had he been the trier of the facts. He would have reached this conclusion applying his instructions to the jury about fair presentation overriding compliance with rules. He also said he didn’t know why the government brought the case. While I agree that the judge’s position did not affect the Circuit Court’s analysis (because there was a jury), it is another irony of this case that the person the defendants wanted to decide the case would have ruled in their favor. To respond to one of Perri’s concerns, I believe I know why the judge did not overturn the jury’s decision, but I do not believe it is appropriate for me to speculate in this letter about the reasons for someone else’s actions.

Perri says I “missed the mark” in my original letter. Actually, he agrees with what I have said, although he may not realize it. Circuit courts are free to disagree with each other (in the absence of a relevant Supreme Court ruling), although they may well be influenced by a well-reasoned opinion of another circuit. Contrary to the implication in Perri’s second paragraph, even a casual reader of my original letter would know I never said (or believed) that a lower court decision does not become law unless the Supreme Court affirms it.

In order to appreciate the mind-set the defendants brought to their work, it is well to remember some of the audit work they performed. Because their audit work raised a serious question about the ability of Valley (an affiliated company) to pay the receivable carried as an asset, the defendants required the debtor to pledge collateral with a value in excess of the receivable. They continued to follow the value of the collateral after the audit report was issued. When the value of the collateral fell below the carrying amount of the receivable, the defendants withdrew the audit report. These latter steps were not then, and are not now, required by generally accepted auditing standards.

In conclusion, I continue to believe that professors Mano, Mouritsen, and Pace have performed a valuable service to the profession by reminding us of the importance of the principle established by Continental Vending. It is a reminder that honorable professionals can have their careers cut short and their lives altered (not for the better) by the whims of a lay jury that doesn’t understand the case it is deciding. In my opinion, this is just what happened to the three defendants in Continental Vending. They were wrongly convicted and had to suffer the unwarranted consequences.

On Extraordinary Items

I read with interest the article “Extraordinary Items: Time to Eliminate the Classification” (February 2007). The authors noted some interesting trends in the changes of the accounting rules with respect to extraordinary items. I find, however, that the analysis and conclusion are somewhat impractical.

We all agree that U.S. GAAP’s treatment of extraordinary items (EI) has morphed over the decades. However, at any given time the treatment for that period would have been consistent for the time of preparation of the financial statements, with little to doubt about period-to-period comparability. The current requirements of SFAS 154 further enforce the retrospective restatement for changes in accounting treatment.

The impracticality test that the authors are referring to with respect to Hurricane Katrina and the September 11, 2001, events are not outside the bounds of GAAP’s approach to EI. On the contrary: When EIs can be measured and recognized, GAAP requires that a separate EI recognition occur. When separating costs from interruption and rebuilding is impractical, EI application is also excluded. I believe that in practice, the results are rather consistent as demonstrated by the EITF decision with respect to these two events.

Finally, in a circuitous argument the authors contend that the “extraordinary items category is used so infrequently in practice” that it should be removed as an option. I find that because events are infrequent in occurrence, the EI events are infrequent. The causality shows that any misuse of EI has subsided, not surged.

In practice I find that EI are a helpful line item to transparently express the state of operations and to capture the true nature of the state of the reporting entity. Events that are infrequent in occurrence and unusual in nature do occur in the small to midsized environment from time to time. Including EI recognition in reporting them as results of operations or even as a change to equity balances would be counterproductive to expressing a fair and true representation of the “facts on the ground.”

The authors respond:

We stand by our conclusion that EI should no longer be a separate section on the income statement. The primary reason is that elimination of the category is consistent with the convergence of FASB and IASB standards. Similar to the rationale underlying the issuance of SFAS 154 relative to accounting changes, exclusion of the EI category would improve financial reporting by eliminating another, in this case, very narrow difference between the two sets of existing accounting standards.

We also agree with the concept that U.S. GAAP should “morph” as new or different circumstances develop. There does not, however, seem to be any basis for the mere passage of time to create different treatment for the same item. With regard specifically to gains and losses on the retirement of debt, the circumstances did not change, merely the treatment. Such a lack of consistency in the classification of the same item over time seems to be in conflict with the beliefs that accounting information should be transparent and simultaneously facilitate the analysis, understanding, and usefulness of the accounting data to readers. One outcome of convergence is supposed to be similar treatment for similar items—a concept that has not always been applied in the past.

As to the classifications of the financial implications of September 11 and Hurricane Katrina as non-extraordinary, we agree that the difficulty of separation between the direct and indirect costs created a substantive problem. On the other hand, the enormity of these two particular losses for many companies pushed the far limits of materiality. A separate line item was essential for full disclosure; the only question was whether that separate line item would be shown net of, or not net of, the tax effects. There is no bottom-line income differential between showing the items as EI or Other Losses; it is simply a placement issue.

We agree that items that are material, unusual in nature, and infrequent in occurrence in the environment in which the business operates should be separately disclosed to “capture the true nature of the state of the reporting entity.” But such separate disclosure can be shown “above the line” in continuing operations and footnoted to provide “a fair and true representation of the facts” that would allow readers to make the most informed assessment of the situation and any potential future implications.