Accounting Standards Approach: Principles-Based vs Rules-Based

Accounting standards plays a vital role in financial accounting and reporting in order for investors to make good decisions. Rules-based accounting is generally a list of detailed rules that must be followed when preparing financial statements. Principle based standards derive from a conceptual framework that provides for broad ‘principles’ to be adopted within standards and also requires professional and managerial judgment in relevance to particular transactions and events. The difference between rules-based and principles-based standards is not clear and is subject to a variety of interpretations. But there is a generally held outlook that the FASB’s standards are rules-based and the IASB’s standards are principles-based.

Principles-Based Accounting Standard

Principles-based accounting standards are based on a conceptual framework. Such standards require a clear hierarchy of overarching concepts, principles that reflect the overarching concepts and limited further guidance. The principles-based deliver a comprehensive way in preparing the financial statement yet has the flexibility to overcome any situations. Sarbanes-Oxley Act of 2002 required the SEC to assess the viability of a principles-based accounting system. The SEC focused their studies on “objective-oriented” standards, which is similar to FASB’s definition of principles-based standards but it is more optimal as it offer a narrower framework that limits the scope of professional judgement but allowing more flexibility.

The main differences between accounting standards developed under a principles-based approach and existing accounting standards are (1) the principles would apply more broadly than under existing standards, thereby providing few, if any, exceptions to the principles and (2) there would be less interpretive and implementation guidance (from all sources, not just the FASB) for applying the standards. Principle based approach will help protect the long term interests of the investors and other stakeholders and will help the director of the companies to make a professional judgement in selecting and applying the most suitable accounting policies.

Six high-quality characteristics of principles-based accounting standard include; faithful presentation of economic reality, responsive to users’ needs for clarity and transparency, consistency with a clear Conceptual Framework, based on a defined scope that addresses a broad area of accounting, written in a clear and understandable language and use of appropriate judgment. The principles-based tend to have more professional judgement. The practice of professional judgment is reinforced to give a true and fair view of the organisation’s performance.

The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes compel managers to manipulate the statements to fit what is compulsory.

Rules-Based Accounting Standard

Rules-based standards have more bright line threshold, more rules, have more scope exceptions and large volume of implementation guidance. Example for bright-line rules-based standards is the managing of capital lease and operating lease. The principle contrast being that a capital lease might need to show up on the asset report of the carrier whereas operating lease do not need any recording. Two distinguishable lease transactions are characterized contrastingly based upon the GAAP renting guidelines.

Rules-based increases the comparability especially when accountants and regulators have different opinions on interpretation of accounting issues.

The FASB developed rules-based standards to increase verifiability for management, auditors and regulators who seek for a clear view of accounting issue. This is related to the reduction in litigation as guidance to protect them from any lawsuits or criticism for aggressive reporting. If organisation fails to conform to these rules, it has to face legal consequences due to the fact that investors entrust the organisation to meet the regulatory requirements and make their decisions based on the interpretation of financial data.

Regulators often prefer rules to avoid unpredictable of later enforcement. Rules reduce discretion of preparer making their judgement less likely to be motivated by the yearning of personal benefits. Moreover, some managers prefer rules-based standards as business arrangement to prepare financial statement. To achieve desirable financial result, they get to gain opportunities by lobbying for treatment of different type of business arrangements.

Why Principles-Based Standards are More Useful than Rules-Based Standards?

Many commentators have suggested that the US accounting standard is more rules-based. Rules are thought to be simple but in reality it could complex and easily be manipulated. For instances, tax regulations are mainly rules-based causing problem to arise when organisation start a new transaction not under the rule guideline. Making it difficult for auditors to clarify the inconsistencies. The complexity of rules can become dysfunctional when the economic changes or when managers structure transactions that meet the rules. Therefore, there’s no need to reduce earnings management and improve the quality of financial reporting because mangers’ will eventually find his way to meet rules by violating them that overcompensate for judgemental discretion. Thus, many regulators are now leaning towards the principles-based approach.

Application of rules-based standard is undesirable because the ‘check-box’ mentality tend to risk the quality of financial reporting whereas principles-based exercises professional judgement. Regulators believe that rules-based approach foster creative accounting, neither comprehensive nor comparable. It is a delusion that rules-based could completely eliminate risk of litigation. Instead of rules-based, principles-based accounting systems provide a true and fair framework with effective communication that are required by stakeholders. Risk of litigation will always remain but principles-based will minimize the risk.

Rules exist because a standard is based on poor principles. Using applicable principle would reduce the need of having detailed set of rules, therefore complexity of the rules could be minimized and standard will increase its comparability. Furthermore principles-based standards are meant to provide a more precise accounting statement reflecting the company’s performance reason because as the used of principles-based increase, manipulation of rules would reduce.

Corporate managers more prefer principles-based accounting standard. Objectives are yet again the flexibility when they could report what they believe of the consequences, beneficial of forecast earnings and if management reimbursement is related to their target. The principles-based focus more on reporting the true economic circumstances, however with that much liberty auditors might challenge management’s misappropriation of standards. Thus, focusing on one or the other standard will not necessary solve the transparency of financial reporting.

There are two matters to take into consideration when engaging into principles-based standards. The issues are to reduce the weighting given to comparability relative to other qualitative characteristics in the conceptual framework and to increase professional judgement in both transaction and financial statement.

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