Going too far is worse than not going far enough: principle-based accounting standards, international harmonization, and the European paradox.

• Author: Rogers, James E.

1. HOW DID WE GET HERE?--ACCOUNTING, FRAUD AND NATIONAL DEBTS OF AFRICAN COUNTRIES II. THE PURPOSE OF ACCOUNTING STANDARDS IS TO PRODUCE RELEVANT, RELIABLE AND CONSISTENTLY COMPARABLE INFORMATION III. THERE ARE FUNDAMENTAL DIFFERENCES BETWEEN PRINCIPLE- AND REGULATION-BASED ACCOUNTING STANDARDS A. Principle-Based Accounting Systems B. Regulation-Based Accounting Systems C. Financial Engineering and Points of Inquiry IV. FINANCIAL ENGINEERING AT ENRON AND WORLDCOM IS NOT THE MAIN REASON FOR CORPORATE SCANDAL A. Enron B. WorldCom C. The Problems V. AMERICA: THE GAAP, GROSS DOMESTIC PRODUCTION, AND INTERNATIONAL HARMONIZATION OF ACCOUNTING STANDARDS VI. INTERNATIONAL ACCOUNTING STANDARDS PRESENT UNIQUE PROBLEMS: "TOMATOES AND TO-MAH-TOES" VII. PRINCIPLE-BASED ACCOUNTING SYSTEMS ARE CONSISTENTLY INCOMPARABLE, GENERATE WASTEFUL LITIGATION AND PROVE UNCERTAIN FOR FINANCIAL DECISIONMAKING A. Consistent Comparability B. Avoidance of Litigation C. Certainty in Decisionmaking VIII. PARMALAT PRESENTS A PARADOX TO EUROPEAN DEMANDS FOR MOVEMENT TOWARD A PRINCIPLE-BASED ACCOUNTING SYSTEM: MILKING LESSONS AND THE GROSS DOMESTIC PRODUCTION OF THE WEST INDIAN ISLANDS IX. SENSATIONALISM: SELLING NEWSPAPERS X. CONCLUSION: PUTTING DESIRED CHANGE IN TUNE WITH DESIRED CONSEQUENCES I. HOW DID WE GET HERE?--ACCOUNTING, FRAUD AND NATIONAL DEBTS OF AFRICAN COUNTRIES

   When the smoke cleared in midsummer 2002, the Federal Government estimated that Andersen Accounting facilitated Enron to overstate its earnings by more than $1 billion. (1) Incidentally, this is greater than the national debts of Botswana, Djibouti, and The Gambia combined. (2) Later, in June 2002, WorldCom revealed that it had "improperly booked" some $3.8 billion in expenses through various accounting oversights. (3) This is greater than the national debts of Botswana, Chad, Djibouti, The Gambia, and Rwanda combined. (4) Deceptions of this magnitude seldom go unchecked and when WorldCom filed for bankruptcy on July 21, 2002, legislation--including the Sarbanes-Oxley Act of 2002 (5)--passed through Congress in an effort to change what many saw as a fatally flawed system of accounting and corporate oversight in the United States. (6)

   Enron and WorldCom made the world community suspicious of American business practices. By pointing to numerous alleged loopholes and various off balance sheet activities that allowed companies to, in essence, legally defraud shareholders and creditors, many observers demanded change. (7) One of the premier proposals critics endorsed was the harmonization of American accounting practices, corporate governance and regulations with their international counterparts. (8)

   The problem is not the movement toward international harmonization, though; the problem is that much of the world community demanded radical changes in American business and accounting practices but refused to adapt their systems in compromise. (9) Using Enron and WorldCom for leverage, European and Asian interests could demand greater change from the United States' regulation-based accounting system while refusing to compromise their principle-based accounting systems. (10)

   As this debate raged, on July 30, 2002, supporters of international principle-based accounting won a major victory when Sarbanes-Oxley passed into public law. (11) Section 108(d) of the act sought to alleviate the accounting loopholes that plagued the Enron and WorldCom scandals by directing the U.S. Securities and Exchange Commission (SEC) to commence a study on the practicality of revising the American Generally Accepted Accounting Standards (GAAP) from regulation- to principle-based. (12) Legitimated by this mandate, the sensationalism surrounding principle-based accounting standards and international harmonization began. (13) Principle-based accounting standards were touted as the savior of American investor confidence, the key to harmonizing international financial interest, and a chance to reincarnate the GAAP. (14)

   In December 2003, the entire dynamic changed again when a European dairy conglomerate named Parmalat came crashing down. In the weeks ahead, investigators revealed that the company had misallocated, misappropriated or simply made up some 8-12 billion [euro] ($10-15 billion) in assets on their balance sheet. (15) As of January 2004, investigators estimated that the now defunct company's gross debt was nearly 15 billion [euro] ($18.8 billion). (16) The fraud ran so deep, in fact, that before the scandal broke, Parmalat recorded an annual gross profit for 2003 of 651 [euro] million ($794 million). In January of 2004, Price Waterhouse Cooper revised that number to a mere 121 million [euro] ($147 million) in annual gross income. (17) Mathematically speaking, Parmalat overstated its annual gross income by 80%. In other words, not only was Parmalat using fraudulent accounting to hide mountains of debt, but it was further using them to create fake profits. (18) With the debt now totaling over 15 billion [euro] ($18.8 billion), no one knows how expensive the tab might end up. (19)

   As a result of the Parmalat scandal, European principle-based accounting was suddenly in a precarious situation. Its advocates faced the "European paradox": why should the United States struggle through the radical change toward principle-based accountancy and international harmonization when companies like Parmalat could achieve greater levels of fraud than Enron and WorldCom? (20) This paradox has thus far gone unanswered.

   This Comment asserts that such a change would not be healthy for a recovering American economy and it is unlikely that a principle-based accounting system will effectively harmonize international accountancy. Further, with the advent of Parmalat, it is becoming clearer that the critics might have been asking the wrong questions all along. As John Oros, Financial Officer to Enodis plc (NYSE/FTSE) asserts, "We should be asking ourselves what good is a principle-based accounting system to an unprincipled person?" (21) Even more poignantly, should we not reconsider the wise words of Confucius: going too far is worse than not going far enough. (22)

   First, this Comment will define the purpose of accounting standards and then highlight the fundamental differences between principle- and regulation-based systems. Then, within the context of the Enron, WorldCom, and Parmalat scandals, this Comment will analyze the concept of "financial engineering" to answer four important questions, namely:

   1. Are the bright lines and specific mandates of the American GAAP to blame for the financial engineering that caused the downfall of Enron and WorldCom?

   2. If so, is this justification enough to abolish our regulation-based accounting system (the GAAP) in favor of a more principle-based system (the IAS)?

   3. What possible incentive does the United States have to move away from the regulation-based GAAP if synonymous frauds can occur in principle-based systems (such as Parmalat)?

   4. Finally, do the incentives to move away from the regulation-based GAAP outweigh the negative impact to the current U.S. economy?

   To answer these four questions, this Comment analyzes American domestic policy, the possibility of international harmonization, sensationalism, and finally, the European paradox. Weighing all these considerations makes it apparent that the American GAAP is the most comprehensive and unwavering accounting system in the world. (23) Further, the GAAP is only partially to blame for Enron and WorldCom, and these scandals do not justify overthrowing it for a system that is less tested and just as flawed. But first, what are the purposes of accounting standards and why are they important?

2. THE PURPOSE OF ACCOUNTING STANDARDS IS TO PRODUCE RELEVANT, RELIABLE AND CONSISTENTLY COMPARABLE INFORMATION

   Financial reporting, or accounting as it is commonly referred, is the process of recording the financial elements of a business enterprise and reporting them to interested parties. (24) The most important purpose of accounting is to explain relevant financial information to interested parties, thereby allowing them to make informed economic decisions. (25) For example, a single company audit will (1) allow executives to better allocate resources between departments, (2) generate quarterly profit estimations to allow investors to decide how best to distribute their funds, and (3) create asset and liability lists for creditors to decide where to loan money. (26) These are all economic decisions that rely on precise financial information for accurate and beneficial choices; they are all decisions entirely dependant on accounting. (27)

   To ensure the best possible decisionmaking, this accounting information must be "useful" to the financial decisionmaking process. (28) The GAAP defines "usefulness for decision making" as meaning that information is (1) relevant, (2) reliable and (3) consistently comparable. (29) Relevance is the ability of information to "make[] a difference to the decision maker in his/her ability to predict events or to confirm or correct expectations[]"; (30) information that is irrelevant is worthless, no matter how accurate it is. (31) Reliability means that the information "portray[s] the important financial relationships of the firm itself," meaning that it can be verified and is dependably neutral. (32) Again, information that is unreliable is worthless, because it cannot be trusted no matter how relevant it is. (33) Finally, information must be consistently comparable with other information to be useful. (34) Specifically, this means that it "allows the users of accounting information to assess the similarities and differences either among different entities for the same time period or for the same entity over different time periods." (35) Consistent comparability is more of a by-product of relevance and reliability: if the information is relevant and reliable, it will be useful to consistently compare...