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Staff Study on Principles-Based Accounting Published

A study by the SEC's Office of the Chief Accountant and the Office of Economic Analysis on the adoption of a principles-based accounting system has been submitted to the Senate Banking Committee and the Financial Services Committee of the U.S. House of Representatives. The study was conducted pursuant to the provisions of Section 108(d) of the Sarbanes-Oxley Act.

The staff study recommended that accounting standards should be developed using a "principles-based" or "objective-oriented" approach. According to the staff, such standards should 1) be based on an improved and consistently applied conceptual framework, 2) clearly state the accounting objective of the standard, 3) provide sufficient detail and structure so that the standard can be used and applied on a consistent basis, 4) minimize the use of exceptions from the standard and 5) avoid the use of percentage or bright-line tests that allow technical compliance with the standard while evading the intent of the standard.

The staff distinguished its objectives-oriented standards from those standards described as "rules-based." According to the staff, a rules-based approach "specifies the appropriate accounting treatment for virtually all possible situations, so that the determination of the appropriate accounting answer is readily determined with little need for professional judgment." The study noted, however, that "significant application of judgment remains necessary in a rules-based environment" and added that "the focus of that judgment is not on capturing the economic substance of the transactions or events, but rather it is shifted to the determination of which of the accounting treatments within a complex maze of scope exceptions." In these cases, rules-based standards "often provide a roadmap to avoidance of the accounting objectives inherent in the standards," concluded the staff.

The study emphasized that the desired approach should be objective-oriented and principle-based, as compared to "principles-only" standard setting. As defined by the staff, principles-only standard setting involves the establishment of high-level standards with little, if any, operational guidance. The study concluded that such a principles-only approach would often provide insufficient guidance to make the standards reliably operational. As a consequence, "principles-only standards typically require preparers and auditors to exercise judgment in accounting for transactions and events without providing a sufficient structure to frame that judgment."

According to the staff, in contrast to the extremes of either rules-based or principles-only standard setting, objective-oriented standards "charge management with the responsibility for capturing within the company's financial reports the economic substance of transactions and events-not abstractly, but as defined specifically and framed by the substantive objectives built into each pertinent standard." In turn, auditors would be held responsible for reporting whether management fulfilled that responsibility.

The staff observed that objective-oriented standards impose a greater responsibility on both management and auditors than do either rules-based standards or principles-only standards. Further, the study concluded that "if properly constructed, objectives-oriented standards could require less use of professional judgment than either rules-based or principles-only standards." Such an application could serve to better facilitate efforts to enforce compliance with the standards, stated the study.

The staff recognized that the Financial Accounting Standards Board has begun the shift to objective-oriented standard on a prospective, project-by-project basis. The FASB is expected to continue to move towards objective-oriented standard setting on a transitional or evolutionary basis. A key point of emphasis in the process, stated the staff, will be to continue the efforts on the convergence of U.S., foreign and international accounting standards.

¨ The staff study will be published in a forthcoming REPORT .