PwC IFRS blog

Improvements in US financial reporting – another step towards principles-based standards?

In my previous posting, I raised the perennial question of whether the future of accounting lies in a principles-based or rules-based world. We often read that there is reluctance in the US to taking too many steps towards a more principles-based model. Well, in mid-January a committee of the SEC published a draft decision memorandum setting out initial proposals to do just that. While it is focused on the US reporting model, and the role of the SEC and the FASB in particular, the memorandum gives an encouraging insight into where US thinking is moving.

The report is just over 100 pages long and is broader than the question of principles versus rules. But it makes some important observations on how standard setters, regulators, preparers and auditors can contribute if a more principles-based framework is to become a reality.

The role of the standard setters and regulators

The report comments that while the current US system has been "quite effective", it has evolved over many years with some of the basic principles becoming obfuscated by detailed rules, bright lines, exceptions and regulations, which reduce transparency and usefulness of the resulting financial reporting. The main recommendations here, which I would applaud, are:

• Additional user/investor involvement in the standard setting process is central to improving financial reporting.
• The creation of a formal Agenda Advisory Group, improving the prioritisation of work, procedures for field testing, field visits and cost benefit analysis.
• SEC to encourage an objective-based approach to the way standards are designed and implemented.

The Committee is also considering proposing that the SEC formally encourage improvement in the way standards are written - using an agreed upon framework that promotes trust and confidence in efficient markets by encouraging the use of professional judgements made in good faith.

The year-end process

The preparers of financial statements and the audit profession have their part to play too. The report recommends that the SEC should issue guidance reinforcing the following concepts:

• Evaluation of materiality should be based on the perception of a reasonable investor.
• This should reflect how an error impacts the total mix of information available to a reasonable investor.
• The evaluation of errors should be on a sliding scale where qualitative factors influence the decision.

The importance of professional judgement is emphasised. The Committee recognises that "many regulators appear to encourage a system in which professionals can use their judgement in determining the most appropriate accounting and disclosure for a particular transaction”. In this context the Committee recommends that the SEC should adopt a similar approach.

Conclusion

All in all, I think the report has real substance and should be seen very positively by those outside the US.  Clearly it is only the beginning of a process of change but I am encouraged – not only because of the issues being identified and addressed, but also because, without this contribution, the process of convergence to a higher quality reporting model would be even harder to envisage.  If you do find the time to read the report, I would be really interested in your views, please drop me a line by email or by commenting here.

Are we paying enough attention to principles?

The complexity of financial reporting has caused concern in recent years and prompted more people to join the debate about the benefits of principles over a rules-based system of accounting.

It is easy to repeat the mantra that principles are good and rules are bad. But in reality neither a purely rules-based nor a purely principles-based system has ever existed. Each accounting standard sits on a spectrum between rules and principles. Many commentators argue that, today, we are too skewed towards the rules-based end of the spectrum and the focus for standard setters should be on pushing the pendulum towards more principles-based standards and a greater use of judgement.

As a contribution to the debate, the large accounting firms published a white paper ‘Principles-based accounting standards’ to coincide with the Global Public Policy Symposium hosted by the firms in New York last month. The paper proposes a framework to use in developing principles-based standards and suggests changes needed on the part of participants in the financial reporting process to support such a system.

The white paper proposes six characteristics that the firms believe are the key elements of a high-quality, principles-based accounting standard: 

1. Faithful presentation of economic reality
2. Responsive to users' needs for clarity and transparency
3. Consistent with a clear Conceptual Framework
4. Based on an appropriately-defined scope that addresses a broad area of accounting
5. Written in clear, concise and plain language
6. Allows for the use of reasonable judgement.

While each of the six characteristics is fundamental to the success of any principles-based system, the first two are regarded as pre-eminent. The need for them should be self-evident. Indeed, the whole purpose of requiring companies to publish audited financial statements is to provide investors with a tool to gauge economic and management performance and prospects. Yet the reality is that under today’s accounting this goal is often not met. Companies can comply with the strict letter of the requirements, yet may fail to provide the information that provides a clear picture of their results or financial position.

In the UK, some fourteen years ago, the Accounting Standards Boards issued a standard by the name of FRS 5, Reporting the substance of transactions. As its name suggests, the objective of this standard is to ensure that the substance of an entity’s transactions is reported in its financial statements. This basic principle of ‘substance over form’ is also enshrined in the IASB’s Framework for the preparation and presentation of financial statements, so what is so different about the UK standard? Arguably nothing, but the status of FRS 5 as an accounting standard in the UK does seem to have had an impact on the mindset of financial statement preparers and other participants in the financial reporting process.

The IASB is working on updating its Framework, but is also pressing ahead with other important projects in parallel. In other words, there does not seem to be too much concern about details of particular standards being finalised before there is agreement on the underlying principles.

What do you think about this approach? How should the IASB go about determining its priorities for the future? Are the projects on the current agenda so important that progress needs to be made urgently? Or is insufficient attention being paid to agreeing the principles in the Framework? Should the IASB develop a standard dealing specifically with reporting the substance of transactions, rather like the UK’s FRS 5? 

As always, I would be interested in your views either by commenting here or by email.