While there is much to criticize in U.S. GAAP -- from its obsessive but ultimately unproductive (perhaps even counter-productive) efforts to write detailed rules for every variation of economic transaction, to its inability to respond timely to emerging reporting needs -- and indeed praise is owed to IASB's more principles-based, less minutely prescriptive approach, the Economist is guilty here of misdiagnosing the problem. Overwhelmingly, recent financial reporting dust-ups have been the result of deliberate management-led financial reporting frauds, often but not always abetted by auditor negligence or acquiescence, and sometimes (but rarely) by actual auditor collusion in fraud.  But the problem is not the result of bad rules, per se, but with the brazen and intentional flouting of those rules.

Now more than ever, accountants and financial professionals need to understand and apply GAAP.  Wiley GAAP 2002: Interpretations and Applications of Generally Accepted Accounting Principles 2002 by Patrick R. Delaney, Barry J. Epstein, Ralph Nach, and Susan Weiss Budak

U.S. GAAP has evolved over the decades from a more principles-based set of guidelines (that is, broad principles such as "revenue cannot be recognized until it is actually realized") to an enormously detailed set of prescriptions (e.g., "revenue from the sale of computer software can be recognized when all of the following five conditions have been met") for what the standard setters hope (foolishly) will cover every conceivable type of economic event or transaction to be reported upon in an entity's statements.  Where once men and women possessing suitable education and professional demeanor would reason by analogy from general principles to specific circumstances -- and would unrelentingly face down recalcitrant clients to uphold the positions they had reached through deductive logic -- today the attitude is that, unless there is an explicit rule, exactly on point, prohibiting the client's desired accounting treatment, it must be allowed.  Put another way, the floor has become the ceiling, with minimum standards becoming maximum requirements to be imposed on clients.

The explanations for why this change occurred are well known.  Changes in societal norms, the self-indulgent "do your own thing" behavioral model, increased world-wide competition, explosive growth in individual shareholdings, lowered educational standards and the oft-stated inability of the accounting profession to attract the "best and brightest" who presumably could function under principles-based rules -- all these and more have been cited as reasons why cookbook recipe type accounting standards had to be developed.  Unfortunately, even if partially fact-based, this logic has been largely self-defeating, as clever clients and investment bankers have remained one step ahead of the accounting rule makers, so that the standards have always been subject to being seriously gamed.

"How many bright professionals really want to commit to a career that involves only looking up highly detailed rules, many with little in the way of true conceptual underpinnings, only to find that clients have already read those same rules and have devised the means to avert them?"

The classic example of this syndrome, of course, comes from one of FASB's early "victories" -- when it addressed the then-rampant problem of property purchases and associated debt obligations being disguised as nominal leases.  In response, FASB Statement No. 13 established four criteria which were intended, collectively, to assure that all property transactions which in economic terms were really acquisitions were recorded as such, with assets and debt on the property user's books, even if fashioned as leases.  One of the four tests mandated that if the user (lessee) was obligated to pay 90% of the fair value of the property over the lease term, it was to be accounted for as a purchase, not a lease.  No surprise -- financing firms quickly adapted to writing "89%" leases.  (FASB 13 was subsequently amended or interpreted by almost 50 other standards, in the never ending effort to close  yet more newly discovered loopholes.)

The point is that the accountants, relying on iron clad and often awkwardly worded rules in the context of a dynamically changing economic environment, with a surfeit of clever lawyers and financiers lying in wait for them, face a hopeless struggle.  Furthermore, the rules-based approach has in all likelihood contributed to, if not entirely created, the very problem -- a diminishing supply of "best and brightest" accountants capable of applying broad principles -- this standard setting paradigm was purportedly a reaction against.  After all, how many bright professionals really want to commit to a career that involves only looking up highly detailed rules, many with little in the way of true conceptual underpinnings, only to find that clients have already read those same rules and have devised the means to avert them?

Nine resources for detecting and preventing accounting fraud

The approach of the IASB, on the other hand, is essentially that of U.S. GAAP before the 1970s.  Broad principles are mandated, leaving room for those so inclined to easily structure transactions around them -- but also leaving professionals with room, and perhaps the incentive, to reason by analogy when faced with unanticipated variations.  For many reasons, this is a preferable approach to accounting standard setting.  If coupled with meaningful enforcement mechanisms, perhaps even including the establishment of an "accounting court" (an idea first touted by legendary Arthur Andersen CEO Leonard Spacek forty years ago -- the ultimate irony in light of Andersen's serial failures as auditors in recent years), this might restore true professionalism and ultimately curb the rampant abuses so much in the news these days.

Having thus paid just tribute to the IASB's approach to standard setting, however, it again must be stressed that financial reporting fraud is just that -- fraud.  As such, it can be and doubtless is being perpetrated by companies reporting under IAS (or U.K. GAAP, German GAAP, etc.).  While there may be reasons to ditch U.S. GAAP, the Enron fiasco is not one of them.

The Economist properly notes that any set of accounting rules can be gamed by those intent on doing so, and that the problems are mainly ethical, not technical.  It also correctly identifies the deficiencies in auditing standards (e.g., the profession's longstanding reluctance to admit that one objective of a financial statement audit is to search for fraud) and practices.  In fact, better auditing would have identified virtually all of the recently notorious financial statement frauds that the auditors were not already complicit in.

For the record, contrary to what the Economist article stated, a shift to IAS from U.S. GAAP would be quite simple to accommodate.  IAS does not mandate "fair value" accounting for tangible plant assets -- the benchmark method is the same historical cost accounting as under U.S. GAAP.  (IAS does permit booking inflation adjustments as an alternative to historical costing, but few companies actually do this -- and for many years during the more inflationary 1970s and 1980s U.S. GAAP required supplemental inflation adjusted disclosures for plant assets and inventories, also.)  IAS does offer a bit more flexibility in some areas, but generally tracks U.S. GAAP rather closely.

There are changes that should be made to U.S. GAAP, which the Enron case, among others, placed in bold relief.  Chief among these is the need to eliminate the "special purpose entities" rules that permit "off the balance sheet" transactions and debt.  Stronger adherence to a "substance over form" requirement, with a concomitant need to consolidate all "controlled" (even if only minority-owned) affiliates, would have stopped the Enron fraud cold. 

Fix GAAP, don't abandon it -- and put teeth into enforcement so that compliance with the spirit as well as the letter of GAAP becomes the only viable alternative.

RALPH NACH, Partner, Altschuler Melvoin & Glasser, CPAs, is co-author of Wiley GAAP 2002.