The Securities and Exchange Commission (SEC) has released a staff study recommending the adoption by the U.S. financial reporting system of a principles-based accounting system.

Congress' intent in requesting the study was to have the staff consider whether a different standard-setting paradigm from the one that exists today would be beneficial to U.S. investors.

Imperfections in both rules-based accounting systems (which allows for circumventing the intent of a standard) and principles-only accounting systems (which provides little guidance for the exercise of professional judgment of auditors) have led the SEC to recommend to those involved in the standard-setting process a more consistent development of standards on a principles-based or objectives-oriented basis.

Principles-based standards, according to the staff report, should have the following characteristics:

• Be based on an improved and consistently applied conceptual framework;

• Clearly state the accounting objective of the standard;
• Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;
• Minimize the use of exceptions from the standard;
• Avoid use of percentage tests ("bright-lines") that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.

To distinguish the particular approach taken to implementing principles-based standard setting, the staff labels its approach "objectives-oriented." This approach requires the standards to clearly establish the objectives and the accounting model for the class of transactions, while also providing management and auditors with a framework that is sufficiently detailed for the standards to be operational.

The staff concludes in the study that an objectives-oriented approach should ultimately result in more meaningful and informative financial reporting to investors and also would hold management and auditors responsible for ensuring that financial reporting complies with the objectives of the standards.

To institutionalize an objectives-oriented approach to standard setting in the U.S., the following key steps are suggested:

• Ensure that newly-developed standards articulate the accounting objectives and avoid scope exceptions, bright-lines and excessive detail;

• Address deficiencies and inconsistencies in the conceptual framework;
• When developing new standards, ensure that they are aligned with an improved conceptual framework;
• Address current standards that are more rules-based;
• Redefine the GAAP hierarchy; and
• Continue efforts on convergence of U.S., foreign, and international accounting standards.

SEC Chairman William H. Donaldson said, "In its reaffirmation of the FASB as the accounting standard setter, the Commission stated that it will continue to monitor the FASB's procedures, qualifications, capabilities, activities, and the results of its standard setting activities. The approach to establishing accounting standards is an important part of our evaluation of the FASB's activities. I want to commend the staffs of the Office of the Chief Accountant and the Office of Economic Analysis for their thoughtful study, which endorses an approach to setting accounting standards that should result in investors receiving more transparent information about a company's financial results and position. We look forward to working with the FASB as they continue to implement this approach."

The full text of the staff study can be found at http://www.sec.gov/news/studies/principlesbasedstand.htm.