Rules Based Versus Principles Based Accounting Standards
These longer-run considerations lead directly to the question of rules-based versus principles-based accounting standards. Rules-based standards attempt to lay down detailed rules for how to account. An alternative to detailed rules, however, is for accounting standards to lay down general principles only, and rely on auditor professional judgement to ensure that application of the standards is not misleading. For example, FASB Interpretation No. 46 (FIN 46). This standard imposed rules for consolidation of variable interest entities, following the abuse by Enron of earlier rules. However, the new rules were in turn circumvented by many financial institutions through the creation of expected loss notes. A principles-based standard for consolidation would require that consolidation be required when failure to do so would be misleading. Thus, if the accountant/auditor felt that excessive financial leverage was otherwise being disguised, he/she would insist on consolidation or, at least, clear supplementary disclosure.
It is often stated that IASB standards are more principles-based than those of the United States. 25 However, Ball (2009) argues that U.S. financial reporting is inherently principles-based, in the sense that the U.S. justice system punishes misleading financial statement reporting even if the financial statements are technically in accordance with GAAP. 26 Ball attributes the rules-based nature of U.S. financial reporting to its high degree of regulation and possible punishment, which produces a “rule-checking” mentality. Undoubtedly, punishment is a powerful deterrent to fraud. But, the prospect of punishment is not always effective. Furthermore, the serious impacts of the 2007–2008 market meltdowns raise the question of whether the world can afford to wait until the wheels of justice grind to their conclusion. It would be preferable to prevent misleading reporting in the first place.
Principles-based standards are seen as a way to accomplish this, since detailed rules do not seem to work. Of course, professional accounting bodies already encourage principled behaviour, through codes of professional conduct, discipline committees, and the process of standard setting. However, Ball points out that such rules have been widely ignored. Nevertheless, the SEC, in “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act … (2003),” recommends that the FASB adopt a principles-based approach to accounting standards. The SEC study is in broad agreement with the FASB’s own 2002 “Proposal for a Principles-based Approach to U.S. Standard-setting.” Furthermore, a stated goal of the Conceptual Framework is to create a foundation for principles-based standards. Without such a foundation, it is unclear just what principles are to be upheld. It thus seems that the world is moving toward principles-based standards. Yet, even with a strong conceptual framework, such standards will face pressures from managers, and even governments, to bend financial reporting to their wishes. To resist such pressures, auditors and accountants will have to adopt the longer-term view of their responsibilities.
- Scott, W. R. (2015). Financial Accounting Theory 7th Pearson Canada Inc. ISBN 978-0-13-298466-9.
- Google Image (2021).