SEC Comm. Evans Espoused Principles-Based Regulation Back in 1973

As the move towards principles-based regulation and standards gains steam, I have been concerned about a growing general perception that US federal securities regulation is prescriptive and behind the curve. Partially, this perception is fueled by the Sarbanes-Oxley Act, which is viewed internationally, particularly in the European Union, as a prescriptive-based regime. The basic tenor is that the US is not on the cutting-edge of principles-based regulation.

I believe that this view is somewhat unfair. I would point out that as early as 1973 SEC Commissioner John Evans was advocating steps to strengthen the outside auditors’ position in meeting their professional responsibilities by adopting rules intended to discourage accountant shopping when there are disagreements with the accountant over matters of accounting principles or practices. I view Commissioner Evans as one of the best and most thoughtful members of the Commission in recent memory.

In what I submit is a principles-based approach, Commissioner Evans said that, in addition to the analysis of various individual transactions, the overall impression left by the financial statements is part of the responsibility of the public accountants. Statements cannot simply be the accumulation of data relating to individual transactions viewed in isolation. In other words, he continued, the accountant has a responsibility to assure that the financial statements fairly represent the company’s financial condition. Fair representation may, and often does, require more than just the use of selected GAAP. This speech is posted on the SEC Historical Commission website.

Thus, as far back as 1973, the Commission was advocating a principles-based approach to financial statements and their independent audits. In 2002, SEC Chairman Harvey Pitt reiterated the Commission’s position that literal compliance with US GAAP is not enough if the financial statements do not fairly represent the company’s financial condition. The chairman alluded to a 1969 Second Circuit Court of Appeals opinion, in which the court held that literal compliance with GAAP does not insulate an accountant if the financial statements create a fraudulent or misleading impression in the minds of shareholders. US v. Simon (CA-2 1969), 1969-1970 CCH Dec. ¶92,511. This principle is now codified in Sarbanes-Oxley, which requires the CEO and CFO to certify that the financial statements fairly present the company’s financial condition.

Admittedly, this principle lost favor during the Enron-WorldCom era, but it was always there, lurking in the background. The return of this principle to prominence is a welcome event that demonstrates a US commitment to principles-based regulation. And let us reflect that, in Simon, Judge Friendly was on the cutting edge.