While there exist a number of causes of the breakdown in corporate governance and financial reporting during the past few years, I shall concentrate on three of them. These causes include the weakness seemingly inherent in the FASB, the low power possessed by the auditing firms, and the need to enforce the rules by punishing violators. If Congress and the SEC had addressed these problems earlier, there would be little need to think about rules-based versus objectives-oriented principles-based standards setting. That debate would then appear trivial.
I realize that the mandate -- I mean the directive -- contained in the Sarbanes-Oxley Act called for the SEC to investigate the feasibility of implementing a principles-based accounting scheme. Despite this instruction, I think the SEC staff should have discussed the context of standards setting in the United States, including the institutional and organizational framework. Ignoring the context of standards setting stripped the staff's report of any lasting significance.
An endemic feature of the U.S. structure is the underlying weakness of the FASB. It has the power to promulgate financial accounting statements, but no power to enforce them. For example, Statement 140 requires business enterprises that employ securitizations to provide certain disclosures. A study by D. Skipworth, however, reveals that except for financial institutions, many corporations ignore this decree (Skipworth, D. 2001. Statement 140A Study of Securitization Disclosures. Research Report. Norwalk CT: FASB). The FASB cannot do a thing about it. Of course, the SEC can; but strangely it does nothing.
The depth of this crisis emerged in the 1990s when the FASB planned to issue a standard requiring companies to expense stock options. Howling in disgust like pampered children, corporate managers ran to Congress with their complaints in one hand and the promise of campaign contributions in the other. As we learned, Congress doesn't care a fig about accounting; several senators and representatives introduced legislation to emasculate the FASB of what little power it has.
It won't matter whether the FASB issues rules or principles or objectives-oriented statements. Until its power increases, that concern deals only with symptoms.
Another feature of the current governance system is the relatively low power of the auditor vis-à-vis corporate managers. Bob Sterling pointed this out in his 1973 article "Accounting Power" in the Journal of Accountancy. At the root of this low power, in my judgment, is the institution of having the one being evaluated paying the fees of the auditor. Sometimes it's hard to keep the business when the "client" plays hardball.
Congress ignored this aspect of the accounting infrastructure when it debated the Sarbanes-Oxley bill. Various suggestions have been introduced from time to time on how to address this problem, such as establishing an agency to assign auditors to firms or employing government auditors to perform the task. These and other alternatives should be explored to remedy this situation.
The last key issue, which is barely mentioned in the staff report, is that of enforcement. The SEC knew about Waste Management's accounting abuses, but did precious little about it. Sunbeam fiddled with revenue recognition, but the SEC merely slapped Al Dunlap on the knuckles. I believe this lack of enforcement encouraged Jeff Skilling and Ken Lay to pillage Enron's shareholders, and this scenario played out in many other corporations as well. Unless and until the SEC and the Justice Department gets serious with white-collar crime, the problems won't go away. And objectives-oriented standards won't help one bit.
I realize that the SEC and the Justice Department have stepped up their enforcement actions. The question at this point is whether this will continue.
In conclusion, the staff dealt with relatively minor issues in its report. While Congress asked the SEC to examine the nature and the feasibility of principles-based accounting, the staff could have shown some wisdom by placing the issue in context. By discussing the more important matters, it would have drawn public attention to them and maybe, just maybe, Congress would have acted in a more intelligent manner than it did when it passed the Sarbanes-Oxley bill.
J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals.