Rules, Principles, and the Accounting Crisis in the United States

The Sarbanes-Oxley Act and the Securities Exchange Commission move too quickly ·when they prod the Financial Accounting Standards Board, the standard setter for US GAAP, to move immediately to a principles-based system. Priorities respecting reform of corporate reporting in the US need to be ordered more carefully. Incentive problems impairing audit performance should be solved first through institutional reform insulating the audit from the negative impact of rent-seeking and solving adverse selection problems otherwise affecting audit practice. So long as auditor independence and management incentives respecting accounting treatments remain suspect. the US reporting system holds out no actor plausibly positioned to take responsibility for the delicate law-to~fact applications that are the hallmarks o f principles- based systems. Principles, taken alone, do little to constrain rent-seeking behaviour. In a world of captured regulators, they invite applications that suit the regulated actor\u27s interests. Rules, with all their flaws, better constrain managers and compromised auditors. Broad brush reformulations of rules based GAAP should follow only when institutional reforms have succeeded