July 11, 2005
Too many rules
Posted by Darren Roulstone

A common question following the revelation of accounting frauds (such as those at WorldCom and Enron) is how such frauds developed within the complex U.S. system of accounting regulation.  One answer is that accounting rules themselves are the problem; or rather, the reliance on a rules-based system contributes to complicated schemes designed to get around the rules. 

A nice discussion of this idea is found in the  congressional testimony of Roderick M. Hills   (Chairman of the SEC from 1975-1977) in a hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies."  Hills argues that today's regulatory environment lays out precise rules that simply provide executives with guidance on what they can get away with.  Hills quotes Paul Brown of New York University's accounting department: "It's the old adage of a F.A.S.B. rule.  It takes four years to write it, and it takes four minutes for an astute investment banker to get around it."

And given the existence of the rules, getting around them is seen as acceptable: "The system has been so precise so many times in saying what cannot be done that it has created an implication that whatever is not prohibited is permitted.  In law school this phenomena has long been known as: 'Expressio unius exclusio alterius.' "

Hills also cites my colleague Roman Weil, who has made similar arguments: "Weil, Professor of Accounting at the Graduate School of Business of the University of Chicago...has pointed out that today auditors, confronted with a somewhat different transaction, ask either FASB or the Emerging Issues Task Force (created by FASB and the SEC) for a new rule.  Instead of making their own judgement drawn from a conceptual framework, they seek the comfort of specificity..."   

Hills states: "The sad truth is that the profession has lost sight of the significance of the signature line of the opinions they give to all their clients.  That line reads: 'In our opinion, the financial statements [prepared by management] fairly present, in all material respects, the financial position of the company.'  Today that broad statement means only: 'We have looked but have found no material violation of applicable rules and regulations.'  Auditors should be more willing to qualify their opinion by saying: 'The company has satisfied all the rules but its financial statements do not fairly present its financial position.' "

Hills goes on to discuss the role of audit committees in preventing fraud as well as possible solutions to the problem of "too many rules."  One cautionary note: Although I mentioned WorldCom at the start of this post, it is not a good example of this problem.  WorldCom concerned a blatant mis-application of accounting rules.  Enron, in contrast, involved (among other things) complicated structures designed to satisfy the rules even though they mis-represented the company's financial position.  Roman Weil described this contrast wonderfully: "Enron is complicated; WorldCom is something we teach in week one."

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