The Principles Verse Rules Based Accounting Standard Debate Accounting Essay
The post Enron scandal escalated to the on-going principles-verse-rules-based debate. In response to the rules-based approach which was criticised as a result of the Enron scandal, SEC proposed a ‘roadmap’ which was to be used by US firms in applying US GAAP when reporting financial statement. The distinction between principle-based and rules-based accounting standards is not yet well defined; as a result it has led to different interpretation of what the standards convey. This paper goes on to distinguish the differences and similarities between rules and principles-based accounting system. Furthermore, highlighting the advantages and disadvantages of principles-based that organisations adopting IFRS standards are likely to encounter after the adoption. I conclude that a fair principles-based approach requires a more reasonable professional judgment at both the transaction (substance over form) and financial level. Overall, for the convergence process to be successful, both standards boards (FASB and IASB) must agree on the required weightings that auditors must give when making professional judgements.
Keywords: Principle-based approach; Rule-based approach; True and Fair View; US GAAP, IFRS; FASB; Professional judgement; Bright-lines; Leases; Litigation.
This extended essay aims to critically analyse the on-going debate between principles-based accounting and rules-based accounting. Since there have been different opinions about the true meaning of what principle-based means, this paper starts off by defining what both the concept means alongside explaining what rules-based accounting .
In the early 2000, there were accounting scandals that shocked the world (WorldCom and Enron). The details of Enron’s bankruptcy was revealed, and showed how Enron skilfully took advantage of the fine details of US accounting standards and manipulated accounting threshold for legal and illegal dealings (Ijiri, 2005). Professional judgment in accounting and financial reporting alongside rules played a role in the crisis of Enron. This led to the debate of whether U.S. GAAP rules-based approach should be abandoned, and adopt a more principle-based approach (IFRS).
After the occurrence of the scandals, supporters of principle-based approach blamed rules-based for the failure these scandals. It is believed that the rules-based approach will encourage the use of financial arranging of information in order to achieve the preferred accounting results without paying attention to specific rules. This however, resulted in poor financial reporting. As a result of having such detailed and comprehensive rules, it gave a window of opportunity for preparers to easily manipulate and restructure financial information for the organisations’ benefit without consideration of the specific rules and guidelines.
Rules-based accounting is known to put great efforts on compliance  , rather than effective communication. Writers that believe in the rules-based concept argue that principles-based approach depends heavily on judgment, which might reduce consistency  and comparability  of information (financial and accounting). In contrast, Andrews (2002) and Hofheinz (2002) both emphasised that supporters of IAS believe that the lack of guidance from the principles-based approach makes organisations and audit firms more restrained and as a result, the need for misuse of the system is reduced.
Almost every organisation is required to prepare financial statement which is set out by the either Financial Accounting Standard Board (FASB) or IFRS depending on the standard that is adopted in that country (Investopedia, 2012). Although, with the approaching global convergence of IFRS in countries, organisations are expected to report financial information based on IFRS standards. Further into the collapse of Enron, the US financial reporting standard was heavily criticised which as a result led to the US congress questioning the nature of rules in their accounting standards. As a result of this, the SOX 2002 required SEC to conduct a study in the "the adoption by the US financial reporting system of a principle-based accounting system" (Section 108 (d)) (SEC, 2003).
1.3 Principles-based approach has been associated with different terminologies likewise the rules-based standard. Based on Grant Thornton (2008) Definition, it states that an ‘appropriate principles-based approach must be broad in its scope’. This standard requires a clear hierarchy of primary concepts with limited guidance. The additional guidance provided should be limited to a concise explanation that is built into the standard itself as well as having a small number of interpretations on key issues which cannot be comprehended (ICAS, 2006b).
Based on ICAS, (2006; p4) illustration of principles, they defined principles as a "general statement with widespread of support which is intended to provide truth and fairness" in the utmost way possible. Moreover, some rules may be proposed to ‘guide the adherence of principles’ but at the end of the day, it always results in making professional reasonable judgments.
Shortridge and Myring (2004) literature highlighted the 2002 presentation which Robert Herz (Chairman of FASB) explained the concept of principle-based standards. He stated that under the principles-based approach, the key objectives of a good reporting are laid out as the starting point. This is followed by providing guidance which explains the objectives therefore relating it to some examples. However, applications of rules are in some situations unavoidable when reporting. Thus, when auditors are in doubt about the credibility of information, they can be directed back to making professional judgments.
1.4 Rules provide a "means of establishing an unambiguous decision making method" (ICAS, 2006b; p4). For example, rules are like computer games without using its specific instruction it might be difficult to navigate. A rules-based accounting standard adds excessive complexity, which facilitates financial engineering and does not reflect a ‘true and fair view accounting (ICAS, 2006b). The fundamental flaw of the standard is due to having unnecessary complexity surrounding each specific elements of the standard. As a result of this, financial reporters and auditors are forced to focus more on the "trees" and less on the "forest" when presenting financial statement (Grant Thornton, 2008; p5). The financial information is presented to investors and other stakeholders for decision making purposes and also to know the overall performance and economic state of the company.
Albert Einstein once said that "Everything should be made as simple as possible but not simpler" (ICAS, 2006; p1). This signifies that accounting standards should be firmly governed by high-level principles making sure at least additional guidance is given to make the standard operational (ICAS, 2006). Based on ICAS (2006) view, they believe that can it be clearly argued that a rules-based standard may have no future when preparing financial statement which aim is to serve the public interest. However, it is still inconclusive about where the future of rules lies as rules still plays an important role for preparers, as rules deals with specific standards unlike the principles-based standard. Principles-based approach seems to be the way forward as the new form of reporting financial information (statements). It also addresses the concern that the supporters of rules-based face in accounting standards such as rules-based having too many bright lines and no or less room for judgement (ICAS, 2006).
According to the Principles versus Rules Working Group set up by the ICAS 2006, it states that only the principles-based approach to accounting can fully serve the needs of businesses and the public interest as a whole. In order for principles-based to serve its purpose, SEC (2003) set out certain characteristics that has to be met by the standard if it is to be classified as principles-based standard. Characteristics such as;
Be based on an improved and consistently applied conceptual framework;
Clearly state the accounting objective of the standard;
Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;
Minimize exceptions from the standard;
Avoid use of percentage tests (‘bright-lines’) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.
Adapted from ICAS, 2006; p26
This paper also identifies the differences between the two accounting standards, also highlighting the need for US GAAP to adopt a more principle-based approach. This paper will also look at both companies and auditors perspective of the two accounting standards. Finally I will make arguments based on why I think principle-based approach is the way forward.
2.1- LITERATURE REVIEW
The increased globalisation of activities has resulted in an increased demand for high-quality international financial information. High-quality accounting standards are important to the efficient functioning of the economy (Jermakowicz and McGuire, 2002). This is due to decisions about allocation of resources is relied heavily upon through credible and understandable financial information (Jermakowicz and McGuire, 2002). From a US perspective, Nelson 2003 and Schipper 2003 both agreed that the US standard is based on a recognizable set of principles which is derived from the FASB  . FASB standards are largely based on conceptual framework which is accompanied with a very detailed and implementation guidance. However, different researchers have found US GAAP to be rule-based even when the standard itself is principle-based.
The rules-based approach which was developed in the US resulted from a history of aggressive regulation of financial reporting (ICAS, 2006). This later led to series of other development as each success of the standard led to the increased tendency to establish even more rules. This was largely driven by the desire for comparability, the more comparability, the more rules have to be put into place in order to enforce the comparability (ICAS, 2006). As a result of this, there is the desire for comparability as well as a quest for principle-based approach. ICAS, (2006) states that it is easy to recognise comparability but it is never possible recognise complete comparability in accounting. The rule-based approach tends to be very detailed and in most cases consisting of hundreds of detailed pages which financial statement preparers have to abide by. Rules-based standard is also influenced by the need for certainty under the risk of legal action against companies and auditors.
Alexander (2006) and others believe US GAAP is overly rules-based because it reflects a ‘cookbook’ approach. However, there is no clear explanation as to what the cookbook approach signifies but it propose it’s an effort to tell ‘preparers and auditors of financial information what to be do’ (Alexander, 2006 p134). GAAP became under increased criticism because some end-users believed it is also a contributing factor in several accounting scandals (Enron) and business failures. Hence, it brought about the argument that the rule-based approach is too complex and difficult to implement with several scopes and exceptions (Schipper, 2003). Kohlbeck and Warfield (2010; pp59) therefore mentioned that if the claims of US GAAP been overly rule-based and complex are true which adds to transaction structuring, then the "attributes should result in lower quality accounting report as new standards are implemented". While on the other hand, principle-based approach is emphasized to have more professional judgments on financial information.
Furthermore, due to large criticisms of rules-based standard, it has prompted a paradigm shift towards a principles-based accounting standard by the US SEC  . The proposed roadmap (Figure 1) by the US SEC showed several milestones that had to be covered and if achieved could lead to the adoption of IFRS by US companies. The new proposed standards ‘principle-based’ is set to apply a much more broad approach than the existing standard, fewer exceptions and less explanatory and implementation guidance (Bradley and Schroder, 2012).
The diagram below illustrates SEC roadmap towards the adoption of IFRS.
Figure 1 - SEC Roadmap milestone. (FST, 2013)
It appears that both the IASB and FASB have a common agreement which is ‘principle-based’ so as to provide solution to the problem of poor financial reporting. Though, FASB standards are based on its conceptual framework. Interested parties believe that principle-based model will lead to a higher quality financial reporting with less opportunity to exploit the gaps in GAAP (Agoglia et al., 2011). For instance, organisations such as Computer Science Corporation, PwC and etc. remarked that the principles-based approach would result in transactions being accounted for in accordance to its economic substance rather than form (Agoglia et al., 2011). While a principles-based approach might be able to achieve these characteristics, others argued that less specificity in accounting standard would result in an increase in manipulation of financial results (Agoglia et al., 2011). IBM, Goldman Sachs, and BDO Seidman expressed their concerns for inter-firm comparability issue. This states that an increase in reliance based judgement and implementation of principles-based standards could result in a decline in comparability across firms (Agoglia et al., 2011).
Agoglia et al., (2011) further highlighted that the on-going debate of whether to move towards a more principle-based accounting reflects the uncertainty of both anticipated desirable and undesirable effect of such as paradigm shift.
The FASB principles-based approach proposal suggested that such a change into this approach will require significant changes such as; behavioural and methodological. The changes have to be acceptable by both preparers, auditors and standards setters about the new approach (principle-based) of financial reporting which places great reliance on professional judgement (Duchac, 2004). Moreover, for the new approach to be successful, it "would require significant improvement to the conceptual framework" (Duchac, 2004 pp. 334). Thus, it might require the US adopting the International Financial Reporting Standard (IFRS) and not just implementing some of IFRS standards, this will also help maintain consistency in financial reporting. However, several UK auditors, corporate directors and other participants such as KPMG have voiced their concerns that the convergence process of US GAAP to IFRS is likely for IFRS to become more rules-based (Jamal and Tan Hun-Tong, 2009). This is due to the pressure that is likely to be encountered in the USA.
Furthermore, the principle-based accounting approach is set to have more reliance on professional judgements. FASB believes that an "approach focusing more clearly on the principles of accounting standards is necessary to improve the quality and transparency of US financial accounting and reporting" (FASB, 2002, p. 10). Graham Ward highlighted that "accountants and auditors in the United kingdom (UK) and the European Union (EU) clearly believe that the principles-based approach is the right approach" (Ward, 2005, p.64). If end-users of the standards believe that principles-based approach is the right approach, surely it can be argued that the accounting standard should be able to achieve other objectives such as enabling true and fair view accounting. ICAS, 2006 stated that the key to having a true and fair financial statement reporting which can be relied upon by investors and other stakeholder is the ability to have a ‘balanced exercise of judgement’. If all standard setters as well as auditors and regulators are able to exercise judgement on broadly equal terms, thus this will help provide a healthy tension which is required for true and fair financial reporting and easy communication with stakeholders (ICAS, 2006).
However, there is also the view that principles-only standards may present enforcement difficulties because they provide insufficient structure as a basis for ensuring ‘compliance’. A view was also expressed by ICAS, 2006 (pg. 10) which states that ‘most audit failures arose through lack of judgement rather than non-compliance with rules’
According to Weil 2002 pg. 3, he states that rules-based standard leads to a "show me where it says I can’t" attitude which often results in an ineffective financial reporting behaviour. As a result of this attitude, extremely detailed reporting guidance can lead to transaction structuring in order to achieve their preferred accounting treatments without taking account of the likely risk such as litigation. Bennett et al. (2006) concluded that two issues need to addressed by the standard setters before a move towards a more principles-based approach; Firstly, reduction in the weighting given to comparability and consistency which is comparative to other qualitative characteristics in the conceptual framework. Secondly, increase in the number of professional judgement in standards given mostly at the transaction level (i.e. economic substance over form of the transaction must be accounted for) and also at the financial level (applying a true and fair view override).
2.2- Why is the U.S. standards commonly perceived to be rules-based?
The difference in drafting some of the accounting standards may give financial information preparers the impression that the U.S GAAP standard is rules-based. For example SFAS 2 (Research and Development) provides a set of rules on the elements of cost. While IAS 9 and FRS 13 (Financial Instrument) provides a general definition followed by examples and guidance notes (Bennett et al., 2006). However, even when there is no difference in the application of SFAS 2 by the standard practitioners, SFAS 2 will still appear rules-based due to the way it is been recognised on the financial statement. However, Nelson (2003) mentioned that the IAS rule is relatively a younger standard compared to the FASB and as a result had less time to increase rules. While, SFAS 2 standard is much older and less likely to capture possible cross-referencing within a more recent standard Bennett et al. (2006).
Based on Benston et al. 2006, he stated that rules-based standards has developed over time due to the demand by financial statement preparers and auditors, which they believe that such detailed rules will protect them from potential blame for aggressive reporting. Justifying aggressive reporting in a less precise standard is likely to be difficult in which thresholds are not explicitly stated (Maines, 2007). Agoglia et al. (2011) concluded that preparers of financial statement are less likely to report in an aggressive way when using a less precise financial reporting standard than when applying a more precise standard.
There is also the issue that even if the text of the standard is drawn up broadly (principles)- there is a possibility that detailed rules of guidance are created to make its application more rules-based.
2.3- Is it a case of ‘bright line’ or ‘professional judgement’?
‘According to former chairman of the U.S. SEC, Harvey L. Pitt, rules-based accounting standards have resulted in financial engineering techniques designed to achieve accounting objectives rather than economic objectives (Pitt, 2002; Alexander, 2006). In the UK, such detailed rules are referred to as ‘bright lines’. Bright line are viewed to be disguising rather than highlighting the core principles, encouraging accurate interpretation and increasing the scope for avoidance (Tweedie, 2002; Lord Sharman of Redlynch, 2002) when reporting financial information.
‘Bright line’  test might help in exercising judgements and could also ensure consistency in the application of standards and hence greater comparability of financial statements (Bennett et al., 2006, p. 199). However, when principles-based is associated with assets and liabilities, the approach might not lead to consistency without the need of extensive guidance; hence it could render such a standard rules-based (Benston et al., 2006, p. 172). Evidence has shown from the ‘accounting experience’ which suggested that, standards that have some but not all of the characteristics of a ‘principles-based’ standard may achieve objectives (Alexander, 2006) such as consistency, comparability and relevance.
On one hand detailed rules promotes consistency and provide authoritative support for financial decision making, while a general principles provides little or no immediate guidance on how to handle difficult scenario in practice (Duchac 2004). This is associated with principles-based relying heavily on professional judgements in order to arrive at conclusion that reflects the economics of fundamental transactions. Bright line rules might restrain from the use of judgements. However, there are still some end-users (such as preparers, standard setters and auditors) who are still motivated into using this sort of approach even when the system does not reflect an economic objective of accounting. According to Duchac 2004, he states that the existence of bright-line accounting approach provides auditors with procedures that defines’ the appropriate financial reporting practice in an impersonal and consistent way. If auditors were forced to make judgements based on accounting principles, potential difficulties are likely to be encountered and accountability questions may be asked over the validity of the judgements made. However, a clearly defined accounting rule helps auditors avoid potential argumentative situations because the organized rules provide specific support for the auditor’s decisions (Duchac, 2004). In addition, the quest for bright-line accounting rules has shifted the goal of professional judgment from consideration of the best accounting treatment to concern for parsing the letter of the rule (ICAS, 2006b).
With the on-going debate about the effect of principles versus rules-based, less attention are paid to the role of auditors in implementing GAAP (Jamal and Tong Tan, 2009). Based on Jamal and Tong Tan, (2009) research, they concluded that auditors that are principles- oriented enforce the substance of accounting rules. The adoption of a principles-based standard will have a significant effect on discouraging CFO from making incentive compatible choices. With these combined together (principle oriented auditors and principle based approach); it will reduce the incidence of proposed lease transaction being reported off the balance sheet. This result reflects Sir David Tweedie (2002b) statement in which he argued that a principles-based system requires both financial statement preparers and auditors to work together in order to reflect the economic substance of transactions in the financial statements.
Jamal and Tong Tan (2009) stated that there are two dimensions which auditors can adhere to when the rules and principles standards are conflicting. Firstly, auditors who are determined on enforcing an accounting standard can do so by being reasonably more strict and firm by ensuring that the underlying principles of the standard are adhered to. Such auditors are considered to be principles-oriented even if the specific rules in the standard are not met hence, capturing the economic substance of the transaction. Or alternatively, an auditor that is rule-based oriented ensures that specific principles are adhered to with less consideration for the underlying principles of the standard. This can be done with the use of strict or firm guidance (Jamal and Tong Tan, 2009). Therefore, PCAOB  (2007) believes rules-oriented auditors can be blamed for excessive re-statements by companies and inadequate fraud detection work.
Due to managers using accounting standards to opportunistically move debt off balance sheet, regulators and standard setters have considered the adoption of principle-based accounting in order to reduce such opportunism. However, there are still concerns as to whether principle-based accounting can be properly implemented and enforced so as to reduce the opportunism. "Accounting standard that is principles-based can potentially reduce opportunities for managers to achieve their incentive-driven accounting choices". However, if the auditor is more rules-oriented (rather than principles-oriented), the underlying principle of the principles-based standard is not likely to be enforced and managers can use seemingly rule-like provisions or exceptions in the standard to achieve their desired accounting choices, even if these are inconsistent with underlying accounting principles Jamal and Tong Tan, (2009).
3.1- DISTINCTIONS AND SIMILARITIES BETWEEN RULE VERSES PRINCIPLE BASED APPROACH
Presumably, if an undergraduate accounting student was to be asked to identify the main distinction between the US GAAP and IFRS, the most likely response would be that the US GAAP is rules-based while IFRS is principle-based. This notion was prompted by Sir David Tweedie and as a result became a perspective that people believed in.
The exact definitions of these standards are still not well defined and often unclear as to what the definition conveys. However, Ball (2008) argues that, contrary to general belief, the U.S. accounting system can be viewed as principles-based at the court level. He further pointed out the 1969 criminal case of the ‘U.S. vs. Simon’ in which the U.S. Supreme Court essentially adopted a principles-based view of accounting. Hence, the evolution of U.S. GAAP to a rules-based approach may have resulted as a result of age and also due to the demand for greater specificity and guidance which gradually grew as the original standards were stressed, tested and further developed (Hail et al., 2009). So therefore, the key difference between the two accounting standards is the amount of discretion that firms and managers have.
Schipper (2003) emphasised that referring to US GAAP as a rules-based system is a great mistake. She claims that US GAAP should be viewed as principles and rules-based approach instead. She highlighted the FASB’s effort in developing its conceptual framework in which principles are the guidelines and from the principle, rules are derived. Rules are the guidelines which are used in implementing the principles. Thus, the difference between IAS and US GAAP is not on the principle but rather on the rules which are omitted in IAS (Ijiri, 2005).
Rules-based system approaches financial reporting as an act of compliance and attempts to tell preparers ‘what to do’ as it uses a check-box mentality. While principle-based system act as a communication link between preparers, it also attempts to guide practitioners (preparers and auditors) in deciding what need to be done when reporting financial information.
Both approaches share some similarities such as; they both share the same financial reporting purpose –which is to give an understanding of the principal economics of an organisation (Alexander, 2006). Furthermore, Tweedie (1983) mentioned that both approaches serve the function of enlightenment when reporting. Functioning as enlightenment could also be regarded as one of their differences- as both approaches have different approaches in achieving the "financial reporting purpose of enlightenment" (Stuebs and Thomas, 2011 p. 50). Likewise, Schipper, 2003; Bennett et al., 2006; Nelson, 2003 agreed that rules and principles-based standards both contain similar content as they both include rules and are based on principles. In Duchac 2004 literature, based on the study carried out by the SEC which was to consider the potential results of both standards (rules and principles-based), they concluded that both standards are problematic. Principle-based system specifically because in theory it is difficult to have principles without elements of rules associated with it. Thus, without the element of rules, it is likely to result in various interpretation and inconsistent application (FASRI, 2013). Therefore as a result both approaches cannot be separated but rather finding the right amount of guidance to associate with the principles will prove to achieve best results in financial reporting.
3.2- REASONS WHY RULES ARE NOT THE ANSWER
Rules-based accounting approach establishes series of bright lines that allow people to ‘play the system’ at the expense of the relevant principle (ICAS, 2006). An example of bright line is- fixed percentages (leases) within standards. It is used as a surrogate for a broader assessment of an issue, thereby taking away any element of judgement. Having hundreds of pages of detailed rules leads to complexity which as a result in users focusing on the letter, rather than the spirit of the standard. It appears that rule-based approach drives request for greater or more details which arises due to both preparers and auditors wanting to minimise the risk of lawsuits. This has made preparers of financial statement believe that if rules are followed, it could exempt them from sanctions.
3.3- ACCOUNTING FOR LEASE- An illustration
Lease accounting under the US GAAP system and IFRS accounting standard best illustrates the differences between principles-based approach and rules-based approach. Leasing is an importance source of finance for many organisations. Therefore, it is important to disclose all leasing activities in the financial statement in full for users of the financial statement. The prevailing accounting lease method requires lessees to classify the leases as either an operating lease or a capital lease (FASB ED, 2010). Nonetheless, the accounting lease methods have been criticised because it had failed to meet users’ needs in providing honest representation of lease transactions. Particularly, it omits important information about "rights and obligations which meets the definition of assets and liabilities in accordance to the conceptual framework" (FASB ED, 2010; 1). The U.S GAAP lease accounting standard (ASC 840) contains a large amount of bright-line support which lead to lack of comparability and unwarranted complexity. In contrast, the IFRS lease accounting standard (IAS 17) contains far less bright-line guidance although there is still the split between operating and finance lease. Hence, it requires preparers to exercise professional judgment in reporting financial and accounting information for decision making purpose (Collins et al., 2012). IFRS requirement states that lease should be capitalized as an asset and liability when all risk and rewards have been ‘substantially transferred to the lessee’ (Nobes, 2005). The IFRS lease technique is based on the principle of economic substance. Under the US GAAP lease structure, a lease is considered as a capital lease if any (at least one) of the following criteria’s are met;
Ownership transfer- ownership rights of the property are transferred by the end of the lease agreement/term.
Bargain purchase option- the lease contains a choice whereby the Lessee has a choice to purchase the leased asset at the price which is lower than the fair value.
Economic life: the term of the lease is equal to 75% or greater than 75% of the economic lifespan of the leased asset.
Minimum lease payment: the present value of the minimum lease payment equals 90% or exceeds 90% of the fair value of the leased asset which excludes any investment tax credit.
Adapted from (CPA, 2013)
These classifications can be regarded as examples of bright-line percentage test whereby criteria three and four contain strict percentage test. While in contrast to IAS 17, there are no strict percentage rule but however, it uses terminologies such as ‘substantial’ which requires exercise of judgement when interpreting the lease agreement.
It is also possible that the manner in which CFOs react to a proposed standards may be different from how they react to an actual standards. For example, once there is familiarity with such a standard, they may develop ways to get around using the standard in order to make their work easier rather than complying with the actual standards (Jamal and Tong Tan (2009).
Due to having bright-lines tests, financial statement preparers have used the opportunity to structure and interpret lease contracts in order to avoid capitalisation as it tends to portray a positive outlook on the company’s financial statement (Imhoff and Thomas, 1988).
The vast majority to leases are classified as operating leases as lease payments are from rental expense therefore, no asset or liability is recognised in the balance sheet (Thompson Coburn, 2012).The FASB and IASB project therefore proposed a change to the lease accounting rules which will effectively eliminate operating lease accounting. The main aim of the proposal is to improve transparency in the financial reporting of leasing activities (Thompson Coburn, 2012).
3.4- PERSPECTIVE (COMPANIES AND AUDITORS)
For U.S. companies, the transition to IFRS (principles-based standards) will lead to reductions in duplication of efforts and complexity in financial reporting. The adoption of principles-based standards will allow for common policies and consistency across the organisation. Thus, it offers greater flexibility in the usage of the standard especially in the finance department (Wright, 2011). There is the lack of extensive rules and detailed guidance for handling exception in the IFRS principle-based approach. As a result of fewer rules and exceptions, companies are required to establish a more robust policies and procedures. These procedures are established internally in order to ensure that judgements are made unfailingly throughout the organisation.
There is a shift in auditors’ perspective when standards require a substantial amount of professional judgements when reporting financial statement for decision making purpose. Auditors tend to comply with the underlying standard in order to avoid litigation. Jamal and Tong Tan, 2009 emphasised that auditors’ characteristics matters when implementing the principles or rules-based approach. Furthermore, ‘while the FASB may push for standards to be more principles-based, there are increased legal penalties from the Sarbanes-Oxley Act (SOX) and inspections by PCAOB’. Ultimately, this may lead auditors towards becoming more rules-oriented (Jamal and Tong Tan, 2009).
Nally Dennis (US Chairman and Senior Partner at PwC), strongly believes that the principles-based approach will allow auditors to continue exercising their point of view and also exercise professional judgments. Exercising professional judgment is a crucial part of the financial reporting process (Heffes, 2006). Furthermore, based on the interview conducted by the ICAS (2006); it showed the challenges that auditors face when applying professional judgements. Auditors experience difficulty in terms of defending professional judgments in a litigation situation and also a requirement for judgement might be too challenging to carryout (ICAS, 2006). As a result of this, it is imperative that professional bodies should provide training, ethical and professional support. This will ensure that auditors are able to deliver professional judgement with integrity which will not have detrimental effect on their profession as auditors are accustomed to the rules-based approach.
Additionally, there is also the pressure of interpretation from auditors. Auditors are expected to interpret standards in clients’ favour and also regulators believe that rules can be easily enforced. As a result of this expectation, there is an expectation gap as to what is perceived from auditors. Furthermore, the rules-based approach makes it difficult for auditors to take a step-back and evaluate whether the overall impact is consistent with the objective of the standard (ICAS, 2006b). As a result, auditors have to move away from the check-box mentality in other to protect themselves.
4.1- DISCUSSION AND CONCLUSION
In addition to previous analysis, the principles-based standard is set to allow the application of professional judgements for accountants when assessing the substance of any transaction. This approach is significantly different from the underlying check-box mentality approach which is relatively common in the rules-based standard. Furthermore, Chairman Robert Herz believes that when accountants, auditors and standard setters apply reasonable amount of judgement, it is likely to enhance professionalism in financial statement reporting (Shortridge and Myring, 2004).
One of the advantages of principles-based standard is that, the successful adoption of IFRS principle-based standards is likely to result in easier standards. Rather than having hundreds of pages of detailed standards, Robert Herz claimed that the principle-based standard will only require twelve or less pages long of detailed standard guidance rather than stretching to 200 pages (BusinessWeek, 2002). The alleged principle-based approach is to have less exception and relatively closing the loopholes which makes the US GAAP rules-based (BusinessWeek, 2002).
In contrast, there are potential disadvantages of a principles-based standard. The main drawback of the principles-based standard is the lack of precise guidelines which could relatively lead to inconsistencies in application across the organisation (Shortridge and Myring (2004). For example, majority of firms are required to recognise both assets, expenses and liabilities that conforms with the true definition of a financial instrument which has to be probable, reliable and estimable
Consequently, Schipper 2003 argued that if standards require an increased implementation of professional judgement (for example in measurement). She believes that the amount of expertise knowledge required by both auditors and preparers will shift. Currently in the US, the majority of the recognised standards tend to provide broad discussions about the implementation of the standards. In most cases, the standards include detailed numerical illustration on how the specific facts about the standards should be applied. However, if such guidance’s are eliminated, firms and internal auditors will have to work out which application details to use by looking at the standards intentions (Schipper, 2003). This seems to be important because, most accounting evaluations are based on estimates which as a result require elements of judgments.
The analysis of the principles-based and rules-based debate brought to the conclusion that the US GAAP contains a larger proportion of details in comparison to principles-based accounting. Furthermore, it is safe to say that standards are very detailed relative to those that are likely to be produced under the principles-based approach (Schipper, 2003). The question of how to manage such lengthy transition to a principles-based standard arises when standard setters are rewriting the standards to make sure they are principles-based. During the transition period, the quality of financial reporting temporarily diminishes by certain percentages due to changes in accounting policies. As a result, inconsistencies in reliability and comparability may occur (Schipper, 2003).
Furthermore, based on auditor’s perspective, most accountants seem to prefer the rules-based accounting standard simply because of litigation. Litigation may occur when auditors exercise of professional judgment over bright lines. However, auditors might still find it difficult to make conclusions by following the check-list approach. This is because, in critical situations a rules-based approach cannot be used to make conclusions, auditors are left with making reasonable professional judgments. There is also the possibility that if financial statements adapt the recognised rules, based on this, there is the potential that lawsuits are reduced (Shortridge and Myring 2004).
Over time rules-based accounting has not really worked in practice. Many critics have argued that the present US GAAP system hardly produces accurate financial reporting due to focusing on check list; with less consideration on the fundamental economic reality (Thompson, 2012). Hence, lease accounting may contain hundreds of detailed guidance note and interpretation; as almost all lease assets are excluded from the balance sheet (classified as operating leases rather than capital). As a result, this has led to the creation of financial engineering and regulated transactions designed to bypass the rules (Thompson, 2012).
US GAAP is usually quite specific in the requirement which includes detailed guidance and also since it has been asked by the FASB to show detailed and specific standards. However, companies want comprehensive guidance of standards. This is because it helps to reduce uncertainties about how transactions should be structured, also making sure that the transactions show the true economic substance of the transaction (Jermakowicz and McGuire, 2002). Companies might want comprehensive guidance; auditors however, want precise standards. Such precise standards help to limit disputes with clients and in a litigation situation; it provides a defence for them. Additionally, regulators seem to prefer this standard (rules-based) because such details are assumed to be easier to impose (Jermakowicz and McGuire, 2002).
Additionally, Jermakowicz and McGuire (2002 p16) emphasised on Robert Hertz statement which states that - occasionally rules-based approach has "a dark side", where rules are pushed to the limit and as a result disaster strikes e.g. such the Enron scandal. Hence the rules-based was compared to the British true and fair view principles. Vincent et al., 2003 viewed accounting standard settings process and its products as a scale which is ranging from one end to the other. At one end there are rigid rules while at the other there is an economic based system that requires the use of professional judgments which needs to be exercised by both preparers and auditors. It is impossible to achieve pure-principle based standards. Moreover, the fact that standards occur at all signifies that some elements of rules are required to either simplify conceptual framework or stop possible abuse of the standard (Bennett et al., 2006). It brought to the conclusion that unless these rules are ad hoc, they will be regarded as principles (Bennett et al., 2006).
This paper has explained and described the advantages of US adopting an IFRS principle-based accounting standard. If IFRS is successfully permitted in the US, firms will have to restructure the internal aspect of the organisation for judgment framework - which will demonstrate how accounting decision are to be made based on principles-based accounting standard. This paper also highlighted reasons why most academics and literature perceive US GAAP to be rules-based standard. However, the US GAAP is generally a principles-based which is derived from the conceptual framework. There is a common belief that FASB standards are rules-based. This is because the approach itself contains many bright-line tests, scopes, exceptions and detailed guidance. A rules-based approach also however contains a combination of rules-based and principles-based standards.
Based on Duchac (2004), it highlighted that the recent SEC Study and FASB proposal suggested that standard setters and regulators have familiarised themselves with the dangers which underlies a purely rules-based standard. And also the detrimental effects of not emphasising judgment can have a negative impact on relevance and practicality of financial information (Duchac, 2004). There is still the opportunity for accounting profession (both preparers and auditors) to act based on these fundamental problems. However, it will require an immense effort to change focus from rules to judgments in financial reporting (Duchac, 2004).
I agree with Schipper (2003) which states that the theory of consistency in financial reporting is very important across an organisation. This lead to further agreeing with Schipper (2003) and Nelson (2003) statement that rules-based approach can help an organisation to achieve clarity and comparability to a certain level. Principles-based accounting standard provides an immense base for the preparation of financial information as it offers flexibility in order to deal with different situations as it arises. ICAS, 2006b Working Group recommended that a principles-based standard will leave less scope for people to persuade them that an ‘inappropriate’ interpretation is tolerable (ICAS, 2006b; p3).
Furthermore, especially after the break down of Enron scandal, the risks of litigation for preparers and auditors have risen. Shortridge and Myring (2004) mentioned that if preparers of financial information obey the accepted rules approach, on these bases; there is the likelihood that litigation may be reduced. Based on this, rules-based approach has proved to help both preparers and auditors reduce litigation and as a result, it is still effective and also most auditors seem to prefer this approach of accounting method. The most perceived problem of principles-based approach which is mention by Kivi et al. (2004) is that the approach is too time consuming to enforce. Time consuming in the sense that it will require making professional judgment in uncertain situations where specific rules does not cover when reporting financial statement. The interpretation of principles-based standards would most likely be relied upon based on good faith by those involved (ICAS, 2006). There are still chances that litigation could increase even in situations where the principles-based approach (professional judgement) has been applied in good faith (ICAS, 2006).
Finally, I do not mean to suggest that principles-based accounting standard is the only way forward in financial reporting. Elements of rules associated with principles can help achieve better quality accounting reporting. Every single accounting standard will occur somewhere along the range between rules and principles. The main aim is to seek the "sweet spot" on the continuum (Grant Thornton, 2008; p2). Duchac, 2004 p337 concluded that only through the balance of rules and professional judgment can accounting professional actually be able to achieve an Aristotle’s "golden mean of performance" in reporting financial information. Thus, as a result of this, it is likely to restore the confidence that is lost from the stakeholders in the reporting of financial information. Furthermore, IFRS and FASB have to come to a conclusion as to what degree of bright-line tests and professional judgments are to be used when reporting financial statement. In practice, I believe principles-based can help achieve the desired high quality financial reporting since that is what most organisation are aiming for high quality reporting due to the global convergence.