Litigation-based accounting

There's been more talk about a switch to principles-based accounting with the SEC's announcement that it's considering allowing firms to choose to use international standards. But today's WSJ notes:

even groups that extol the use of broad-brush principles seem to fall back on rules. Last fall, the Committee on Capital Markets Regulation, a group of business leaders and academics whose work was backed by Treasury Secretary Henry Paulson, issued a report pushing a principles-based approach to regulation and accounting in the U.S. The report also called on the SEC to scrap an existing, principles-based standard governing what is important, or material, to a company's results. Instead, the committee called for the SEC to adopt a rule saying companies should only consider as important items that are greater than 5% of pretax profit. That raises the prospect that companies will engineer things so that issues fall below that number. Hal Scott, a Harvard University law professor who helped found the committee, countered that view, saying that the call for a 5% rule came about in response to accountants over-auditing, "because they're afraid of litigation," and so include too many things, when there's just a principle to guide them.

The regulators and standards-setters need to realize that compliance costs depend not just on the rules or principles themselves but on the fact that courts will apply them in civil and criminal cases. Civil damages and even criminal liability are imposed significantly in excess of actual harm. The remedies are imposed on agents who may not reap all the gains from misrepresentations or accuracy, and therefore have an incentive to over-comply. That's also why merely tweaking SOX 404 is unlikely to end the SOX debacle.

In other words, to fix accounting, we need to fix litigation.  This would include safe harbors, damage caps, and even, perhaps, disimplying the private right of action under 10b-5.