Neither organization has given a definition of a rules-based standard-setting process or principles-based standard setting. The two organizations fabricate an ideal of objectives-oriented standard setting, but those of us outside their power structure still wonder what they have in mind. (Academics aren't the only ones living in ivory towers!)

I guess they don't think it important to define their terms, explain what they are up to, or argue why objectives-oriented standard setting (a.k.a. principles-based accounting) is better than rules-based accounting. Given that FASB and the SEC continue to ignore pleas to explain themselves, maybe we can observe recent documents and ascertain the distinctions. For example, let's consider the proposal to amend Statement No. 128 on earnings per share. Assuming that FASB is pursuing principles-based accounting, the revised exposure draft should enunciate the principles and not be overly rules-based.

During 2003, FASB issued its first exposure draft to modify Statement No. 128. The board summarizes the suggested pronouncement in three parts. It would:

a. Amend the computational guidance in Statement 128 for calculating the number of incremental shares included in diluted shares when applying the treasury stock method.

b. Eliminate the provision of Statement 128 that allows an entity to rebut the presumption that contracts that may be settled in either cash or shares will be settled in shares.

c. Require that shares that would be issued upon conversion of a mandatorily convertible instrument be included in the weighted-average number of ordinary shares outstanding used in computing basic earnings per share (EPS) from the date when future conversion becomes mandatory.

FASB published "Earnings per Share: An Amendment of FASB Statement No. 128" on September 30, 2005. This additional adjustment of earnings per share would:

a. Further revise the computational guidance applicable to the treasury stock method to treat the carrying amount of an extinguished liability upon issuance of shares as assumed proceeds in the computation of incremental shares.

b. Eliminate the weighted-average computation for calculating contingently issuable shares and require that contingently issuable shares be included in diluted EPS from the beginning of the period that the conditions for issuance are satisfied, or the date of the contingent share arrangement, if later.

c. Define a mandatorily convertible instrument and clarify that shares that would be issued upon conversion of a mandatorily convertible instrument should be included in the computation of basic EPS whether the effect is dilutive or antidilutive.

d. Clarify that share settlement must be assumed (if dilutive) for the purpose of computing diluted EPS for an otherwise cash-settled instrument that contains a provision that requires or permits share settlement under certain conditions.

Let's begin at the beginning -- what's the objective of these exposure drafts? For that matter, what's the objective of Statement No. 128? Why do accountants have to figure out corporate EPS; after all, that sounds like the job of financial analysts. True, the accounting profession might standardize how business entities compute these metrics, but if that is so important, why don't we standardize the measurement of other important metrics, such as free cash flow? On the other hand, given recent games of some high-tech companies, one wonders how much standardization we are really achieving.

Both the first and the second exposure drafts provide computational guidance to users when employing the treasury stock method. But, computational guidance deals with nuts-and-bolts concerns (rules!) and has nothing to do with principles. For that matter, it isn't clear why FASB imposes the treasury stock method, given that it assumes the counterfactual. The only business enterprises with treasury stock are those who are trying to cover up their tracks dug in by a multitude of stock options.

Ditto the computational guidance for contingently issuable shares. There are no principles involved in this guidance, merely rules.

Ditto mandatorily convertible instruments. FASB enunciates no principles, and I certainly don't see any. I see arbitrary rules instead.

And ditto the settlement issue.

So from our observations, the exposure drafts do not provide or utilize any principles or objectives. These documents provide rules that allow managers and auditors to create checkboxes; they don't generate any real benefits for society.

It is telling that FASB amended several small items in the first exposure draft only to amend them a different way in the second exposure draft. Frankly, the smallness of the topics is incredible. Does FASB have so little to do that it has to spend time on minutiae?

In the meantime, I still don't know the difference between principles-based and rules-based accounting.

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J. EDWARD KETZ (edketz@psu.edu) is accounting professor 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.