Implication of ethical values for the principles versus rule-based approaches to accounting Standards

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.

(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.

There are 10 principles of the rules-based GAAP accounting system:

• Regularity
• Consistency
• Sincerity with an accurate representation of the company’s financial situation
• Permanence of methods
• No expectation of compensation
• Prudence with no semblance of speculation
• Continuity
• Dividing entries across appropriate periods of time
• Full disclosure in all financial reporting
• Good faith and honesty in all transactions

Principles-Based Accounting vs. Rules-Based Accounting

In accounting, a principles-based on approach is the most popular accounting method globally because it is usually better to adjust accounting principles to a company’s transactions, rather than adjusting a company’s operations to accounting rules. The international financial reporting standards (IFRS) system the most common international accounting standard is a principles-based approach, which states that a company’s financial statements must be understandable, readable, comparable and relevant to current financial transactions.

By contrast, rules-based accounting involves a list of detailed rules that companies and their accountants must follow when preparing financial statements. The major example of rule-based accounting is the Generally Accepted Accounting Principles (GAAP), which is a system broadly used in the U.S. Rules-based accounting involves as the name implies that users follow a list of strict and specific rules that accountants must apply when creating financial statements and other financial documents.

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.

On the other hand, when there are strict rules that need to be followed, like those in the U.S. GAAP system, the possibility of lawsuits is diminished. Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management.

Compliance to GAAP helps to ensure transparency in the financial reporting process by standardizing the various methods, terminology, definitions, and financial ratios. For example, GAAP allows investors to compare the financial statements of two companies by having standardized reporting methods. Companies must formulate their balance sheet, income statement, and cash flow statement in the same manner, so that they can be more easily evaluated.

If companies were able to report their financial numbers in any manner they chose, investors would be open to risk. Without a rules-based accounting system, companies could report only the numbers that made them appear financially successful while avoiding reporting any negative news or losses.