For almost 40 years, a movement has been under way to estab-lish one set of international accounting standards for all coun-tries around the world in order to facilitate international tradeand investment. Since it is no longer unusual to have for-

eign companies list their stock on the New York Stock Exchange,one common set of accounting standards should go a long waytoward increasing the understandability of international financialreports. Until recently, listing rules required that non-U.S. com-panies must reconcile their financial statements prepared underhome country standards to U.S. Generally Accepted AccountingPrinciples (GAAP). However, the SEC now permits foreign com-

panies to use International Financial Reporting Standards(IFRS), established by the International Accounting StandardsBoard (IASB), in lieu of the conversion of foreign financialstatements to GAAP.

On November 14, 2008, the SEC released for comment a pro-posed road map for the adoption of IFRS that would monitorprogress until 2011, when the SEC plans to consider requiringU.S. public companies to file their financial statements using IFRS.The original implementation date of 2014 was pushed back oneyear to 2015 to give the SEC more time to study implementa-tion issues. The United States is under a great deal of pressure

Ethics, Professional Judgment, and Principles-based Decision Making Under IFRS

R E S P O N S I B I L I T I E S & L E A D E R S H I P

e t h i c s

JANUARY 2011 / THE CPA JOURNAL68

By Steven M. Mintz

to adopt IFRS because members of theEuropean Union did so in 2005 and manyother countries have or will be adoptingIFRS by the end of 2011. To date, about120 nations have adopted IFRS as theirhome country standards.

The final decision of the SEC to man-date IFRS starting in 2015 will be basedon whether those accounting standardsare of high quality and sufficiently com-prehensive. The SEC’s convergenceapproach is based on the notion of“improve and adopt” IFRS before givingits stamp of approval. The Commission hasbeen assessing whether IFRS develops ahigh quality of financial reporting relativeto the standards that may be replaced. Agood example of the convergence processat work is the capitalization of finance costsduring the period of construction of anasset. Originally, International AccountingStandard (IAS) 23, Capitalisation ofBorrowing Costs, and a revised versionallowed for capitalization but identifiedexpensing as the benchmark treatment forborrowing costs. In March 2007, the IASBissued another revised version, this timemandating capitalization to bring the stan-dards in line with U.S. GAAP underFASB’s Statement of Financial AccountingStandards (SFAS) 34, Capitalization ofInterest Cost.

In the United States, financial statementsshould contain useful information in accor-dance with GAAP and present fairly finan-cial position, the results of operations,and changes in cash flows. GAAP con-formity depends on a strong set of ethicalvalues to guide behavior, such as objec-tivity and integrity and an ability to makeprofessional judgments with respect to therelevance and reliability of financialinformation. The objectivity and integritystandards in the AICPA Code ofProfessional Conduct provide guidanceon how GAAP conformity issues shouldbe handled and what to do when differ-ences exist between the position of a pro-fessional accountant and one’s supervisor.

IFRS incorporates a principles-basedapproach to standards setting rather thanthe rules-based regime in the United States.Under the principles-based system, con-sideration should be given to the econom-ic substance of financial data and its rep-resentational faithfulness in order to makeprofessional judgments about the useful-

ness of financial information. On an inter-national level, the Global Code of Ethicsissued by the International Federation ofAccountants (IFAC), an organization withrepresentation from professional account-ing associations around the world, providesguidance similar to the integrity and objec-tivity standards, but it is predicated onfollowing principles that underlie decisionmaking, such as economic substance overlegal form and the “true and fair view over-ride.” The latter enables an accountant todeviate from the requirements of anaccounting standard to present fairly finan-cial information.

SEC Study of a Principles-Based SystemThe Sarbanes-Oxley Act called for a

study to be conducted by the SEC of theneed to adopt a principles-based approachto standards setting to replace the morerules-based system in the United States thatis defined by bright-line rules to establishacceptable practices. Critics of a rules-based system point out that bright-line rulesenable a company to structure a transac-tion to achieve technical compliance withthe standard while evading the intent of thestandard. A good example of allowingbright-line rules to determine properaccounting and financial reporting is the3% equity requirement that existed for out-side ownership of special-purpose entities(SPE) that enabled Enron to avoid con-solidating SPE operations with those of thecompany. Under current standards, the“dispersion of risk” requirement of FASBInterpretation (FIN) 46(R), Consolidationof Variable Interest Entities, provides amore conceptual basis to determine whenconsolidation is appropriate and is moreconsistent with a principles-orientedapproach to standards setting.

The SEC study notes that imperfec-tions exist when standards are establishedon either a rules-based or a principles-onlybasis. Principles-only standards may pre-sent enforcement difficulties because theyprovide little guidance or structure for exer-cising professional judgment by preparersand auditors. Rules-based standards oftenprovide a vehicle for circumventing theintention of the standard. As a result of itsstudy, the SEC recommended that thoseinvolved in the standards-setting processmore consistently develop standards onan objectives-oriented basis. Such standards

should have the following characteristics:■ Be based on an improved and consis-tently applied conceptual framework; ■ Clearly state the accounting objectiveof the standard; ■ Provide sufficient detail and structureso that the standard can be operational-ized and applied on a consistent basis; ■ Minimize exceptions from the standard; ■ Avoid use of percentage tests (brightlines) that allow financial engineers toachieve technical compliance with thestandard while evading the intent of thestandard. (“Study Pursuant to Section 108(d) ofthe Sarbanes-Oxley Act of 2002 on theAdoption by the United States FinancialReporting System of a Principles-BasedAccounting System,” www.sec.gov/news/studies/principlesbasedstand.htm)The following statement in the SEC study

describes the Commission’s position:In our view, the optimal principles-basedaccounting standard involves a concisestatement of substantive accounting prin-ciple where the accounting objective hasbeen incorporated as an integral part ofthe standard and where few, if any,exceptions or internal inconsistencies areincluded in the standard. Further, such astandard should provide an appropriateamount of implementation guidancegiven the nature of the class of transac-tions or events and should be devoid ofbright-line tests. Finally, such a standardshould be consistent with, and derivefrom, a coherent conceptual frameworkof financial reporting. The SEC believes that principles-based

standards fail to provide sufficient guidanceon the implementation of principles and relytoo much on professional judgment.However, even under an objectives-orient-ed approach, judgments must be made withrespect to how such objectives are met,given the underlying conceptual frameworkfor financial reporting. These judgments arepredicated on evaluating economic sub-stance over legal form and the representa-tional faithfulness of financial information.Basically, the SEC seems to have adoptedthe objectives-oriented terminology to dis-tinguish its approach from the principles-based system, even though meaningful dif-ferences do not exist.

A more objectives-oriented as well asa principles-based standards regime

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requires professional judgment at both thetransaction level (substance over form)and at the financial statement level (“trueand fair view” override). It is the latterjudgment that is unique to internationalstandards. The IASB’s Framework for thePreparation and Presentation of FinancialStatements (IAS 1), which was reissuedon January 1, 2009 (www.ifrs.org/NR/rdonlyres/4CF78A7B-B237-402A-A031-709A687508A6/0/Framework.pdf), provides that if the application of IFRSconflicts with the provisions of the frame-work so that the financial statements donot “present fairly,” then the entity shouldfirst consider the salutary effects of pro-viding supplementary disclosures. If thedisclosures are insufficient to provide atrue and fair view, then the entity mayconclude that it must override (ignore orcontravene) the applicable accountingstandard. IFRS standards anticipate that

such overrides would be made only in rarecircumstances.

A principles-based approach to deci-sion making is illustrated by emphasizingeconomic substance over legal form inlease transactions. In the United States,SFAS 13, Accounting for Leases, estab-lishes rules that can undermine the sub-stance-over-form concept. For example, ifany one of four lease criteria is met, thencapitalization treatment leads to recordingan asset and liability on the books of thelessee using the present value of futurelease payments, including any guaranteedresidual value. One problem with the rules-based criteria for capitalization is theyrely on implementation guidance (bright-line rules) that can be manipulated. A com-pany might engineer a lease transaction insuch a way as to achieve the desired objec-tive of keeping the liability off its booksrather than faithfully representing theunderlying economic substance of thetransaction. For example, to keep the lia-bility off its books, the lessee simply doesnot have to guarantee to pay the residualvalue to the lessor. Consider the following:Present value of lease payments (exclud-ing residual value) is $107,000; fair valueof leased asset is $120,000; present valueof residual value equals $2,000. If the resid-ual value is unguaranteed, then applyingthe 90%-of-fair-value test for capitalizationleads to a $108,000 amount (90% of$120,000) versus the $107,000 presentvalue, and, assuming none of the other cri-teria are met, the lease is recorded as anoperating lease. Had the residual value beenguaranteed, then the 90% test would haveresulted in capitalization of the lease($109,000 > $108,000).

International accounting standards applya principles-based approach to leaseaccounting. IAS 17, Leases, provides thatif the substance of the transaction is effec-tively to transfer ownership to the lessee,then it is accounted for as a purchase andsale (capitalization). The standard doesestablish criteria that guide capitalizationbut their application relies on professionaljudgment. For example, the lease term mustbe for the major part of the economic lifeof the leased asset, rather than the 75%-of-the-economic-life test in the UnitedStates, and the present value of the mini-mum lease payments must be at least equalto substantially all of the fair value of the

leased asset. In reality, it is difficult to seehow these vaguer standards produce bet-ter results, given that one company mightdecide that the major part is greater than50% of the useful life of the leased asset,while another may say it is 75% or more.The different applications of the standardscan lead to a lack of comparability in finan-cial reports. The problem is that even in aprinciples-based environment, rules mightfactor into the judgments made, therebyeffectively negating the more conceptualprinciples approach. Still, if the accountingfor leases does not conform to financialreporting requirements in the judgment ofthe auditor, then the true and fair viewoverride could lead to capitalizing a leaseto ensure that economic reality is portrayed.

Principles-based standards can be toogeneric and, as opposed to rules-based sys-tems, they do not address every contro-versial issue but keep considerable ambi-guity about such major processes as record-keeping and measurement. As noted in theSEC study, a potential drawback of theprinciples-based approach is a lack ofprecise guidelines, which could createinconsistencies in the application of stan-dards across organizations. One exampleis IAS 16, Property, Plant and Equipment.According to the standard, property,plant, and equipment can be accountedfor under the cost method or the revalua-tion method. Specific rules do not exist toguide when one method should be usedas opposed to the other. Moreover, therevaluations are made at fair value, withlittle guidance to help determine thisamount, except that “fair value is theamount for which an asset could beexchanged between knowledgeable, will-ing parties in an arm’s length transac-tion.” The question is whether determina-tions of fair value can be made objective-ly over time and with sufficient precision.

Representational FaithfulnessOn May 29, 2008, the IASB and FASB

jointly issued an exposure draft on a con-ceptual framework underlying internationalfinancial reporting (“Conceptual Frameworkfor Financial Reporting: The Objective ofFinancial Reporting and QualitativeCharacteristics and Constraints of Decision-Useful Financial Reporting Information,”www.fasb.org/draft/ed_conceptual_framework_for_fin_reporting.pdf). The

EXHIBITDecision Making in a

Principles-Based System

Decision Usefulness

Economic Substance over Legal Form

(true and fair view override)

Representational Faithfulness

Professional Judgment

Objectivity and Integrity

JANUARY 2011 / THE CPA JOURNAL 71

objective is to develop a common concep-tual framework for financial reporting. Onceadopted, it will supersede Statement ofFinancial Accounting Concepts (SFAC) 1,Objectives of Financial Reporting byBusiness Enterprises, and 2, QualitativeCharacteristics of Accounting Information,issued by FASB. Such a framework is essen-tial to fulfilling the boards’ goal of devel-oping standards that are principles-based,internally consistent, and internationally con-verged and that lead to financial reportingthat provides the information that capitalproviders need to make decisions in theircapacity as capital providers. The process isinvolved and lengthy because commentsfrom accounting professionals and organi-zations around the world on the exposuredraft must be evaluated prior to making adecision on the final joint conceptualframework. The boards are in the process ofissuing revised exposure drafts on variouselements of the conceptual framework basedon comments received. On March 11, 2010,FASB and the IASB issued an exposuredraft on the reporting entity concept(“Conceptual Framework for FinancialReporting: The Reporting Entity,”www.ifrs.org/Current+Projects/IASB+Projects/Conceptual+Framework/Conceptual+Framework).

The definition of qualitative characteris-tics of useful information in the May 2008exposure draft is important because thisaspect of the conceptual framework has adirect bearing on making judgments in aprinciples-based system, with respect to whatmakes information useful for decision mak-ing. According to the draft, for financialinformation to be useful it must possess thetwo fundamental qualitative characteristics—relevance and faithful representation.Relevant information is capable of makinga difference in decision making by virtueof its predictive or confirmatory value. Tobe useful in financial reporting, informationmust be a faithful representation of the eco-nomic phenomena that it purports to repre-sent. Faithful representation is attained whenthe depiction of an economic phenomenonis complete, neutral, and free from materialerror. Financial information that faithfullyrepresents an economic phenomenon depictsthe economic substance of the underlyingtransaction, event, or circumstance, whichis not always the same as its legal form.Faithful representation does not imply total

freedom from error in the depiction of aneconomic phenomenon because the eco-nomic phenomena presented in financialreports generally are measured under con-ditions of uncertainty. Therefore, most finan-cial reporting measures involve estimates

of various types that incorporate manage-ment’s judgment. To faithfully represent aneconomic phenomenon, an estimate must bebased on the appropriate inputs, and eachinput must reflect the best available infor-mation. Completeness and neutrality ofestimates (and inputs to estimates) aredesirable; however, some minimum levelof accuracy also is necessary for an estimateto be a faithful representation of an economicphenomenon. For a representation to implya degree of completeness, neutrality, or free-dom from error that is impracticable woulddiminish the extent to which the informationfaithfully represents the economic phenom-ena that it purports to represent. Thus, toattain a faithful representation it sometimesmay be necessary to explicitly disclose thedegree of uncertainty in the reported finan-cial information.

One difference between the exposuredraft and the conceptual framework in theUnited States is to define the qualitativecharacteristics of useful information toinclude faithful representation. Rather thanbeing considered an element of reliability,as in the United States, the faithful repre-sentation of economic phenomena is afoundational element of useful informationin the joint framework. The IASB con-firmed these distinctions at its boardmeeting on September 15, 2009.

Objectivity and Integrity A strong set of ethical values is needed

to make reasoned assessments about repre-sentational faithfulness and to support theprofessional judgments needed to ensure thatfinancial information reflects the economicsubstance of transactions in a principles-based system. Accountants should avoid anytemptation to slant measurements one wayor the other. Instead, the proper accountingshould be objectively determined, and pres-sure to do otherwise should be resisted bymaintaining one’s integrity. Given the impor-tance of representational faithfulness and pro-fessional judgment in a principles-drivenapproach to standards setting, accountingprofessionals need guidance on just whattheir ethical obligations are in making suchjudgments. The AICPA Code of ProfessionalConduct and the Global Code of Ethics pro-vide such guidance.

Rule 102 of the AICPA code obligatesmembers to maintain objectivity andintegrity, be free of conflicts of interest,and not knowingly misrepresent facts orsubordinate judgment to others. Integritymeans to observe both the form and thespirit of technical and ethical standards; cir-cumvention of those standards constitutessubordination of judgment. The usefulnessof information is enhanced by objectivityand integrity because they enable anaccounting professional to withstand pres-sure by a superior to put the best facepossible on the financial statements ratherthan have the statements reflect economicreality. Interpretation 102-4, “Subordinationof Judgment by a Member,” requires thatif differences exist with one’s supervisorwith respect to a disagreement or disputerelating to the preparation of financial state-ments or the recording of transactions, themember should follow certain steps toensure that the situation does not consti-tute a subordination of judgment. One suchstep is to determine whether the desiredtreatment by the supervisor reflects the useof an acceptable alternative and does notmaterially misrepresent the facts. Littleguidance is provided in the interpretationon acceptability judgments.

On an international level, the InternationalEthics Standards Board for Accountants(IESBA) that was established by IFACissued a revised Code of Ethics forProfessional Accountants (Global Code) thatbecame effective on January 1, 2011. The

To attain a faithful representation

it sometimes may be necessary

to explicitly disclose the degree

of uncertainty in the reported

financial information.

JANUARY 2011 / THE CPA JOURNAL72

revised code establishes ethical requirementsfor professional accountants performing ser-vices in the global business arena(www.ifac.org/publications/international-ethics-standards-board-for-accountants/code-of-ethics).

The Global Code provides clearerguidance than Interpretation 102-4 on theconflict resolution process when differencesexist with one’s supervisor. Specifically,the following steps should be taken: 1) determine the relevant facts of each posi-tion, 2) identify the ethical issues involved,3) assess the fundamental principles relat-

ed to the matter in question, 4) considerestablished internal procedures, and 5) identify alternative courses of action.Having considered these issues, the accoun-tant should determine the appropriatecourse of action that is consistent with thefundamental principles identified. Thedetermination of relevant principles shouldbe made in light of judgments about rep-resentational faithfulness and economicsubstance over form.

Decision Making in a Principles-Based System

As previously mentioned, a principles-only approach may provide insufficientguidance to make the standards reliablyoperational. As a consequence, principles-only standards require preparers and audi-tors to exercise significant judgment inapplying overly broad standards to morespecific transactions and events, and oftendo not provide a sufficient structure toframe the judgment that must be made. Theresult of principles-only standards can bea significant loss of comparability amongreporting entities. Furthermore, under a

principles-only standards-setting regime,the increased reliance on the capabilitiesand judgment of preparers and auditorscould increase the likelihood of retrospec-tive disagreements on accounting treat-ments. In turn, this could result in anincreased litigation with regulators for bothcompanies and auditors.

A framework to make professional judg-ments in a principles-based system is pre-sented in the Exhibit. The benefits of theframework include the following: 1) itincorporates elements of professional judg-ment based on standards of objectivity andintegrity, 2) judgments are consistent withevaluations of the representational faith-fulness of financial information, and 3) theframework emphasizes economic substanceover legal form in providing useful finan-cial information. The framework shouldhelp to provide the structure needed in aprinciples-based system to compensatefor the lack of detailed, but often, overlytechnical rules-based standards that rely lesson professional judgment and more onfinding a way around the rules.

Management and Auditors The impending adoption of IFRS and its

principles-based approach will obligateauditors to assess management’s determi-nations with respect to how the financialstatements conform to IFRS and the under-lying principles of economic substance overlegal form and representational faithfulness.Given the degree of judgment required inapplying basic principles to fact situa-tions, the legal liability of auditors maybe ratcheted up one level when comparedto the rules-based system that may providemore defensibility in a court of law.

Richard C. Jones points out in his July2010 article in The CPA Journal (“IFRSAdoption: Some General Issues toRemember”) that in an annual report pre-pared under IFRS, management must takeresponsibility for—or make an assess-ment regarding—whether the financialstatements were prepared in accordancewith IFRS guidance, as required by IAS 1.If compliance with applicable IFRS guid-ance would result in issuing financialreports containing misleading informa-tion, management can depart from theIFRS requirement and apply an account-ing or reporting approach that would allowfor fair presentation (true and fair override).

If a company makes this determination, itwill have to provide detailed disclosuresexplaining the reason for departing fromthe specific IFRS guidance.

Ronald E. Marden and Kennard S.Brackney point out in their June 2009article in The CPA Journal (“Audit Riskand IFRS: Does Increased FlexibilityIncrease Audit Risk?”), which addressesthe complexities of making audit judgmentsin an IFRS-compliant environment, thateven though management compliance withIFRS will become easier, given the flexi-bility those standards offer, the audit pro-cess will likely become more complex,because auditors will need to assess man-agement’s judgments on IFRS complianceand the spirit of the law rather than assesscompliance based on the established U.S.GAAP set of benchmark rules. The resultmay be to pit auditor judgment againstmanagement judgment and to increaseaudit risk if the auditors knowingly fail toappropriately modify their opinion onfinancial statements that are materially mis-stated. The increase in audit risk is due, inpart, to the need for auditors to assess anunfamiliar and seemingly more flexible setof standards that could offer company exec-utives more leeway in managing income.

One possible result of more principles-based standards is legal actions againstboards of directors, audit committees,management accountants, and external audi-tors. In the United States, the first line ofdefense for auditors is to show that theyexercised a reasonable level of care in con-formity with Rule 201 (General Standards)of the AICPA Code of ProfessionalConduct. That standard is met by demon-strating adherence to rules-based GAAP inpreparing and reporting financial informa-tion. Under the principles-based approach,the auditors’ defense should include not onlyadherence to IFRS but also the applicationof judgment in applying those standards ina particular instance. An adequate founda-tion must exist to make such judgments andenhance supportability in a court of law. Theframework developed in this article shouldhelp in that regard. ❑

Steven M. Mintz, DBA, PhD, CPA, is a pro-fessor of accounting in the Orfalea Collegeof Business at California Polytechnic StateUniversity, San Luis Obispo.

The legal liability of auditors

may be ratcheted up one level

when compared to the

rules-based system.

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