Homer & Friends on Lehman Brothers and Accounting Rules v Principles – Part 3

Our panel – Homer Simpson, Henry David Thoreau and Gordon Gekko – completes its discussion of Lehman Brothers and Accounting Rules vs Principles:

Gekko – I'm still in the no harm, no foul camp for accounting that follows the rules – but you  have a point- a time honored one.  Tomes have been written on the fundamental accounting issue of rules vs principles.  If you want to see the fullest expression of rules based accounting – look at tax accounting.  Uncles Sam knows the taxpayers will take advantage of broad principles, so he makes a rule for everything then makes another rule every time someone finds a loophole in the first rule.  The tax laws and regulations fill a room.  In a sense, principles have no loopholes, but they rely on the judgement and ethics of the person doing the accounting.  Apparently Uncle Sam has little confidence in taxpayer ethics.  Even if you could count on ethics, a pure “principles” approach might lead to an awful lot of different accounting treatments for the same types of transactions in financial reporting-  no treat for the investor who wants to understand the financials without reading an encyclopedia of footnotes wit
h each report.

Homer – Doh, guys, I'm not getting this whole ethics thing.

Gekko - Consider this example of rules vs principles from George Aldhizer, who teaches accounting at the Calloway School of Business and Accountancy at Wake Forest University.
"In the Enron debacle, top management followed a fairly obscure detailed accounting rule that said that if at least 3 percent of the equity in a special purpose entity partnership is provided by outside investors, the debt does not have to be disclosed on the balance sheet," Aldhizer says. "Technically, top management did not break the law because they adhered to this specific rule."
However, Enron did not follow the fundamental principles of full disclosure and materiality, he says.
"The full disclosure and materiality principles state that significant transactions that are likely to influence the decision-making process of a reasonably informed investor should be disclosed in the body of the financial statements or footnotes," Aldhizer says.

Thoreau – See, it is a matter of principle.

Gekko – Not so fast, Henry.  If you follow the technical rules and keep the repo account small enough so it has no material impact on the balance sheet, will it “influence the decision of an informed investor?”  In fact you might see Lehman's auditors arguing this in court someday, apparently the periods they certified involved a significantly lesser use of repos as sales than the final (unaudited) quarters before Lehmans collapse.

Thoreau – I still think the accounting for each transaction is a matter of principle.  If the smaller amounts of debt didn't matter to informed investors, then why was Lehman trying to hide them?

Homer – You guys could talk all day.  I quit, pass the donuts.

Gekko:  Here you go Homer, take three.  Henry, you will  have the last word on Lehman Brothers.  But the world is full of companies that will continue to find ways to dress up the quarterly financials a little bit when things are tough, using "gimmicks" that are within the rules, if not the principles. Guess what Henry, if they don't overdo it and they don't go broke, you will never hear anything about it.  You can never close all the loopholes, and if you switch from rules to principles, you might be creating a once in a lifetime opportunity for, well, for guys like me.

Photo Credit: alancleaver 2000