The dilemma of bright line accounting rules and professional judgment: Insights from special purpose entity consolidation rules

Abstract

Special purpose entities (SPEs) gained popularity during the 1990s when they were used as a building block in structured financial transactions. The failure of Enron in late 2001, however, revealed that the accounting for these transactions was based on detailed accounting guidance that often yielded a financial reporting picture that did not reflect the substance of the underlying transaction. In December 2003 the Financial Accounting Standards Board (FASB) issued FIN 46R ‘Consolidation of Variable Interest Entities’, which corrected many of the financial reporting inconsistencies generated by patchwork guidance on consolidation that evolved during the 1990s. This study uses the previous consolidation rules for SPEs to evaluate the impact that bright line accounting rules have on financial reporting decisions. Review of SPE consolidation rules suggests that detailed rules and bright line tests have overshadowed professional judgment, resulting in decisions that were consistent with established rules, but inconsistent with the social policy goal of providing the most useful financial information. In essence, it appears that the detailed rules-based structure of GAAP has squeezed judgment out of the financial reporting system, atrophying the accounting profession's ability to apply sound professional judgment. As a result, the solution to the financial reporting system's current problems may not lie in adding layers of complexity to the existing rule structure, but in developing broader-based principles that encourage and demand individual responsibility and the application of professional judgment.