PICPA - Principles- vs. Rules-Based Accounting

Principles- vs. Rules-Based Accounting

by Raymond Thompson, PhD, CMA

The debate over principles vs. rules has been going on for over a decade. Today, however, the more principles-based IFRS has thrown the issue into sharp relief.

Below are six key elements that require careful consideration before a move to principles-based IFRS can be effective where precise rules and ongoing guidance have been the norm.

  1. Financial markets need to be more sophisticated. Today’s accounting numbers are not exact, as they contain a degree of estimation. From a public company perspective, however, the financial community seems focused on a small set of numbers, such as quarterly earnings per share versus expectations. As long as rewards for “meeting and beating The Street” are great, and as long as the numbers are +/- 10 percent anyway, problems will occur. It would be impossible for management to not consider how specific accounting alternatives could impact reported profits. No system can produce complete uniformity or comparability. More emphasis needs to be placed on the key judgments made by the preparer and the sensitivities surrounding them. Single point estimates are easiest for analysts to work with. Unless they adapt a different approach, many would argue that principles-based accounting cannot succeed in the long run.
  2. Rules-based accounting has not worked in practice. Critics argue that the present U.S. system does not produce accurate reporting. It focuses on “checking the boxes” more than portraying an underlying economic reality. Thus, lease accounting contains hundreds of pages of rules and interpretations while almost no leased assets appear on corporate balance sheets. The system has created an industry of financial engineering and structured transactions designed to circumvent the rules. Many believe that rules closing structuring loopholes will only result in more elaborate ways to circumvent them.
  3. Lacking detailed guidance, management must select the “best approach,” and an auditor will need to accept that treatment. From a public company perspective, this may mean that the Big Four will act as the “uniformity police.” In smaller companies, technical services such as PPC and CCH are likely to remain the de facto rule setters for day-to-day issues. Returning a part of the standard-setting process to the profession is a risk. It is hard to underestimate how much the culture of the profession would change. FASB believes that having companies and their auditors exercising professional judgment requires a strong commitment from preparers…to a faithful presentation of all transactions and a strong commitment from auditors to resist client pressures.
  4. Both IFRS and FASB state that disclosure is not a substitute for recognition. Many believe that even under a principles-based system, there is only one best way to account for any transaction. The reported number may differ by a small amount because of the way the principles are applied, but the underlying approach should remain constant. Principles-based accounting places much more emphasis on explaining the judgments made to arrive at a reporting treatment. This implies that the disclosures accompanying financial statements will become longer and more elaborate.
  5. Many regulators have criticized the present system as one that encourages the following scenario: the quality of financial reporting deteriorates, scandals arise, the SEC investigates and punishes the offender, and FASB closes the loophole. Under the present system, the SEC attempts to ensure uniformity and consistency in financial reporting. However, regulators cannot enforce uniformity in a principles-based system. In addition, the SEC will have much less influence on the International Accounting Standards Board than it has had domestically. Will the SEC resist taking short-term actions to fix immediate problem that might undermine the system in the long run? IFRS are based on countries adopting the standards fully and completely without adding jurisdiction-specific reporting rules. This is not compatible with principles-based accounting.
  6. Many believe that legal considerations drive financial reporting. Under a principles-based system, however, it is possible for two preparers to make different, technically correct judgments. Unless regulators and legislators provide protection to preparers and auditors who make judgments on good faith estimates of uncertain future events, principles-based accounting will fail.

The move towards IFRS and the push-pull of principles- vs. rules-based accounting are perhaps best expressed by Sir David Tweedie, IASB chair:

“We are trying to return accounting to the profession. You have a special situation and come to us and ask what should you do? Our answer will be, ‘Do your best.’ Go away and think about it. Don’t come and ask us because if you do, you will get a rule and off we go.”

Raymond Thompson, PhD, CMA, is an associate professor in the accounting and finance department at the University of Pittsburgh, Johnstown.




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LAST UPDATED 9/14/2009