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Treasury Secretary Urges Principles-Based Accounting and Internal Controls Reform

Treasury Secretary Henry Paulson has strongly endorsed the implementation of a converged principles-based financial accounting system and more efficient internal controls regulations and standards. In remarks before the Economic Club of New York, he also rejected a process-oriented mentality to corporate governance in favor of transparency and sound leadership. While eschewing a legislative fix for the Sarbanes-Oxley Act, Paulson said that the SEC and the PCAOB must implement the Act in ways that better balance the benefits of the legislation with the very significant costs that it imposes, especially on small businesses.

Paulson said the key to effective and efficient financial regulation is striking the right balance. Excessive regulation slows innovation and imposes needless costs on investors. He does not want to see a regulatory race to the bottom in which investor protection is sacrificed in a quest to reduce costs. In his view, the right regulatory balance should marry high standards of integrity and accountability with a strong foundation for innovation, growth and competitiveness.

By far the single biggest challenge with Sarbanes-Oxley is section 404, Paulson said, which requires management to assess the effectiveness of a company's internal controls and requires an auditor's attestation of that assessment. Companies should invest in strong internal controls, and Paulson said that shareholders welcome this development because it is in their best interest. However, he believes that section 404 should be implemented in a more efficient and cost-effective manner. He observed that a significant portion of the time and expense associated with implementing section 404 might have been better focused on direct business matters that create jobs and reward shareholders.

Paulson praised the SEC and the PCAOB as they move towards creating a new and much improved auditing standard aimed at ensuring that the internal control audit is top down, risk-based and focused on what truly matters to the integrity of a company's financial statements. This new guidance for companies and their auditors should encourage common sense reliance on past work, he said, and on the work of others. Paulson is encouraged that the SEC and the PCAOB are going to provide tailored guidance for small companies that recognizes their specific characteristics and needs.

With a nod to the SEC's roadmap to the convergence of U.S. GAAP and IFRS, Paulson remarked on the desirability, where practical, of implementing a principles-based system. He said that added complexity and more rules are not the answer for a system that needs to provide accurate and timely reporting to investors. In his opinion, there is no rules-based haven that will provide investors with an accurate portrayal of a company's financial performance.

Auditors must be able to focus on one fundamental objective, he said, which is ensuring the integrity and economic substance of management's financial statements. To get there, accounting must be recognized as a profession, not a science, which requires judgments that cannot be prescribed in a one-size-fits-all manner that undermines the usefulness of financial statements to investors. Paulson questioned whether auditors seek detailed rules in order to focus on technical compliance rather than using professional judgment that could be second-guessed by the PCAOB or by private litigants.

The IFRS accounting system mandated in the European Union is an excellent principles-based system, in Paulson's view. He explained that a principles-based system is one organized around a relatively small number of ideas or concepts that provide a framework for thinking about specific issues. He believes the advantage of a principles-based system is that it is flexible and sensible in dealing with new or special situations. A rules-based system typically gives more specific guidance than a principles-based system, he said, but it can be too rigid and may lead to a check-the-box approach.

Paulson said that it is not healthy to have only four major accounting firms, all of which are exposed to potentially large liability. Difficult questions must be answered, he said, such as whether the financial accounting system is sufficiently competitive.