Resist shift from principles to rules

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There is a fundamental difficulty with accounting in general that is a particular problem in financial reporting. While the outside world’s perception is that it is an exact science, anyone in accounting knows that this is far from the truth.

This mismatch in perception increasingly makes financial reporting fraught. Judgment is at the heart of accounting. And judgment can only thrive in a system based on principles. If you try to apply specific rules, all that happens is lawyers become even richer and the figures become less trustworthy.

It was this problem that led to the report, “Principles Not Rules: A Question of Judgement”, in April this year by a working group under the aegis of the Institute of Chartered Accountants of Scotland (Icas). The report consulted widely on views round the world and provided much evidence for the desirability of a triumph of principles over rules. As the chairman of the working group, Hugh Shields, head of reporting at Barclays Capital, put it then: “The key to true and fair financial reporting is the balanced exercise of judgment.”

The battle to ensure a principles-based system is now joined. And at an Icas conference last week the evidence was presented. The answer was that, while the basic premise held true, the means of ensuring that it became the reality in the marketplace were as elusive as ever. Much of the mood was one of exasperation. Mr Shields reiterated the fundamental argument that “rules discourage judgment and principles encourage judgment”. And there was no doubt in most speakers’ minds that the principles route was the one that produced the most useful results for investors and preparers alike.

There was frustration and anger in the air. Rules provide more comfort for auditors if lawyers question decisions at a later date. But the result of rules is that financial reporting becomes long-winded and more opaque.

Investors, in particular, are poorly served by this. Douglas Flint, group finance director at HSBC Holdings, provided a simple, graphic example. He said: “Auditors these days are simply trying to avoid criticism.”

The banking group’s annual report and accounts now run to more than 400 pages. He quoted from the broker reaction to them from Goldman Sachs. It started: “The market reaction to HSBC’s results was broadly positive.” But the concluding sentence read: “There was some confusion around the results, with many non-specialists giving up on the 420-page results book.”

Sir David Tweedie, chairman of the International Accounting Standards Board, which is responsible for creating and promulgating the system of international financial reporting standards (IFRS), that are now the norm in Europe and many other parts of the world, gave the rules on leasing, which enable companies to keep huge liabilities out of the key area of their figures, as an example of the perils of rules. One of his mantras is that it is his ambition one day to fly in an aircraft that is on the airline’s balance sheet. Or, as he put it at the conference: “The US standard on leasing is six pages thick and still nothing finishes up on the balance sheet.” This is where the real frustrations over how rules are allowed to get round principles come to the surface.

Now that IFRS has passed the test of its first year of implementation the focus of interest has switched to the matter of interpreting how the standards should be applied in different circumstances. Sir David sees the danger here as shifting the emphasis back from principles to the legal comfort of rules. He wants to force accountants to use their judgment. “When people ask us what they should do we should answer, ‘your best’, and leave it at that,” he said.

The preparers are equally exasperated. Frequently, it was the much more lawyer-dominated and rules-based systems of the US that was criticised.

Mr Flint said he did not know any public company that had not had to go through the process of changing an accounting policy, often at very short notice before publication of the figures and usually as a result of a US interpretation forcefully expressed by lawyers. Such concentration on rules “always leads to arbitrage and unintended consequences”, he said.

Sir David suggested two simple routes to bringing judgment back to the heart of financial reporting. One was a long-term approach to try to bring about a cultural change. “Don’t teach the standards,” he said. “Train people by using the principles.” The other was to insist that people stick to the idea that they should be able to explain a standard in one paragraph and then ask if it makes intuitive sense.

His view was that, if financial reporting was to remain useful rather than arcane, the current efforts to establish the primacy of principles is “our last chance”.

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