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Stated differently, when the registrant fails to apply accounting principles with substantial authoritative support, no amount of disclosure can cure the problem. The corollary to that is also important. The other side of that coin says that even if the accounting is appropriate, without complete and transparent disclosure, the company's filing is still deemed to be deficient. |
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Current authoritative standards, of course, include many of these components. |
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As we have stated previously, professional judgment also is needed to apply rules-based standards. However, in applying rules-based standards, professional judgment is needed to determine where within the numerous scope exceptions and conflicting guidance the company's transaction falls. Indeed, in many respects, the exercise of judgment in an objectives-oriented regime is merely different than under a rules-based regime. When properly constructed, objectives-oriented standards provide a framework for the application of judgment which can result in more consistent judgments than under a rules-based regime. |
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Sometimes referred to as the "show me where it says I have to do it that way" mentality (comments made by participants at the Baruch Roundtable on "Shifting to a Principles-Based Accounting System: Will It Improve Financial Reporting in the U.S.?" February 11, 2003). |
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As we note in our discussion of costs and benefits, it is likely that there will be a net benefit since it is frequently quite expensive to engage the financial engineers. |
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Since rules-based standards require significant judgment to determine where within the complex maze of exceptions and internal inconsistencies a transaction falls, this security blanket may, in fact, provide a false sense of security to auditors. Regarding the role of the auditor, some research seems to indicate that auditors might be more willing to challenge aggressive accounting practices adopted by management in a more "flexible" accounting environment than in an environment of rigid rules. See Nelson, Mark W., "Behavioral Evidence on the Effects of Principles- and Rules-Based Standards," Accounting Horizons, March 2003. Importantly, however, this result appears limited to situations where the auditor is more experienced and in a "stronger" firm. |
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As we have seen, the objectives of financial reporting are to provide information that is useful for investment decision-making. Embedded in this objective is both that transactions should be properly accounted for and that disclosure should be clear and transparent. This is not to say that disclosure should act as a substitute for proper accounting. See, Accounting Series Release No. 4, "Administrative Policy on Financial Statements," April 25, 1938. Rather, as the FASB notes: "Some useful information is better provided by financial statements and some is better provided, or can only be provided, by notes to financial statements or by supplementary information or other means of financial reporting." FASB, Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," December 1984, paragraph 7. |
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If the information provided is to be useful to investors, it should be provided in an understandable manner. As SFAC No. 2 notes: "Information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence." FASB, SFAC No. 2, paragraph 40. |
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In an attempt to more actively engage users in the standard setting process, on February 6, 2003, the FASB announced the creation of a User Advisory Council. According to the FASB, "the purpose of the Council is to assist the FASB in raising awareness of how investors and investment professionals, equity and credit analysts and rating agencies use financial information. The Council will serve as a resource to the FASB both in formulating its technical agenda and on specific projects that the Board undertakes." See, http://www.fasb.org/news/nr020603.shtml. |
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As we described earlier, a move towards objectives-oriented standard setting must be viewed within the context of the reforms mandated by the Act. Thus, as used here, the term "enforcement" is viewed in its broadest context. Enforcement would include not only the enforcement powers of regulatory and legal bodies such as the SEC and the Department of Justice, but it also would include the activities of the PCAOB through its inspection and disciplinary programs, corporate governance efforts of management, audit committees, and boards of directors, the responsibilities of independent auditors, and civil litigation. |
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SEC rules require that listed companies have audit committees that are composed of independent directors; see, Release No. 33-8220, "Standards Relating to Listed Company Audit Committees," April 9, 2003. Additionally, SEC rules require companies to disclose whether any members of the audit committee are audit committee financial experts; see, Release No. 33-8177, "Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002," January 23, 2003. |
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FASB, Proposal: Principles-Based Approach To U.S. Standard Setting, October 21, 2002. |
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See, for example, AAER 1405 and 1410, June 19, 2001. |
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Comments by Sir David Tweedie, Chairman, IASB, made at the FASB Roundtable Discussion on Principles-Based Standards, December 16, 2002. |
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See, for example, Dye, R.A. and E.R. Verrechhia, "Discretion vs. Uniformity: Choices Among GAAP," Accounting Review, 1995 and La Porta, R., F. Lopez-de-Silanes, and A. Shleifer, "Law and Finance," Journal of Political Economy, 1998. |
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As noted earlier, this concern is, in part, caused by the confusion between principles-based standards and principles-only standards. |
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Comments by various participants at the FASB Roundtable Discussion on Principles-Based Standards, December 16, 2002 and by various participants at the Baruch Roundtable on "Shifting to a Principles-Based Accounting System: Will It Improve Financial Reporting in the U.S.?" February 11, 2003. |
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Release No. 33-8183, "Strengthening the Commission's Requirements Regarding Auditor Independence," January 28, 2003. |
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Readers are reminded that the Commission currently has rule proposals outstanding which would address the reporting of "critical accounting policies." See, Release No. 33-8098, "Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies," May 10, 2002. Additionally, the Commission's rules require that auditors communicate critical accounting policies and estimates with the company's audit committee. See, Release No. 33-8183, "Strengthening the Commission's Requirements Regarding Auditor Independence," January 28, 2003. |
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The chart contained in Section VI outlines other steps that are a necessary part of the implementation process. |
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See, for example, comment letter of Stephen J. Cosgrove, Vice President, Corporate Controller, Johnson & Johnson. |
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In that regard, the FASB noted that: "Certain aspects of the conceptual framework are incomplete, internally inconsistent, and lack clarity." For example:
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