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In July, the Securities and Exchange Commission staff took a stand on principle. On principle-based accounting, that is. The SEC recommended that accountants and executives make a revolutionary change: abandon their long-standing practice of relying on specific, detailed accounting rules in favor of an approach based on broad principles. Principle- or objective-based accounting is widely used internationally, particularly in Europe, while the rules-based method has been the U.S. standard for more than 60 years. In 2002, following the massive accounting scandals at the Enron Corp., WorldCom Inc., and other companies, Congress ordered the SEC to study the principle-based approach. Proponents of the change say that traditional rules-based accounting is too complex, involving hundreds of pages of excruciatingly detailed standards. As a result, they say, the standards are too easily manipulated, allowing companies to issue distorted financial results that still technically comply with the rules. By contrast, critics of a principle-based approach contend that it provides too little structure and leaves too much leeway for multiple interpretations of financial results. Among those familiar with both arguments is Roman Weil, V. Duane Rath Professor of Accounting at the University of Chicago Graduate School of Business. In February 2002, while testifying before a congressional committee investigating the Enron scandal, Weil supported a change to principle-based accounting. “Whatever detailed rules accountants write, smart managers can construct transactions the rules don’t cover,” he testified. Weil has advised many companies on corporate governance and accounting issues through the university’s executive education programs. He spoke with contributing writer Anne Stuart of D&O Advisor (a quarterly magazine affiliated with Legal Times) about what a switch to principle-based accounting might mean for boards of directors. Q: What’s the basic objection to rules-based accounting? A: It feeds on itself. The more specialized rules you write, the more you cause the need for more rules. The more rules there are, the more holes there are in the sieve. . . . The title of my testimony before Congress sums it up: “Show me where it says I can’t.” Q: How would principle-based accounting simplify matters? A: Here’s an example. Right now, there are 140 separate rules on revenue recognition. We’ve also got one general principle of revenue recognition [governing precisely when and how companies should "recognize," or report, revenues. Proponents of principle-based accounting are] trying to get rid of these 140 separate rules and have one overarching principle. Q: How would the shift [to principle-based accounting] affect directors’ jobs? A: It would require more understanding of the accounting issues than before. At companies I’ve worked with, directors have had a huge amount of reliance on others’ understanding of accounting. . . . [With principle-based accounting,] they can’t sit there mindlessly and hear what management has to say. They have to understand the principles and the judgments behind the decisions, the wiggle room, what management’s doing, what the auditor’s doing. Too many boards pick members because they say, “I know how to ask the tough questions.” They may know how to ask the tough questions, but they don’t know how to evaluate the answers. Q: Hasn’t the Sarbanes-Oxley Act of 2002 already changed directors’ responsibilities in that direction? A: I think the responsibilities aren’t that different than they were before, but the lawyers are having a field day making sure they’re in compliance. What Sarbanes has done has put into law what the audit committees should have been doing since they were created back in the 1970s: They need to be independent. . . . Ultimately, the auditor needs more power to resist pressure from the [chief financial officer]. Boards still need to make it clear that the auditor works for them — not for the CFO. Q: How can audit committee members prepare for the potential change? A: If you’re on the audit committee, you have to be financially literate. I don’t think there’s any substitute for a board member knowing the fundamentals of accounting: What is an asset, what is revenue, what is a liability? I believe anybody who understands the fundamentals of accounting is going to be OK. The audit committee member [should] understand in his own head or her own head these four things about every accounting judgment or decision: the business transaction, the accounting issues behind that transaction, what were management’s chosen and rejected alternatives, and why they decided what they did. Q: Are most audit committee members willing to learn enough about accounting to do that? A: The typical reaction of an audit committee member is: “That’s too much to ask of me. I am smart enough, networked enough, to be on this audit committee.” But [as a board], you are setting yourself up for liability if you’re not vetting the members of the audit committee to be financially literate. I think it’s going to take a generation or two of board turnover to get truly independent directors and to get rid of the current board members who think this way: “I know how to ask the tough questions.” “Let me ask the CFO.”

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