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Advantages and Disadvantages of Principles-Based Accounting Standards:

The primary advantage of principles-based accounting rests in its broad guidelines that can be applied to numerous situations. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent. A 1981 study sponsored by FASB found evidence that managers purposefully try to structure leases as operating leases to avoid incurring additional liabilities. Providing broad guidelines may improve the representational faithfulness of financial statements.

Principles-based accounting standards allow accountants to apply professional judgement in assessing the substance of a transaction. This approach is substantially different from the underlying 'box-ticking' approach common in rules-based accounting standards. FASB Chair Robert Herz stated that he believes the professionalism of financial statements would be enhanced if accountants are required to utilise their judgement instead of relying on detailed rules. Herz continues that a principles-based system would lead to standards that would be less than 12 pages long, instead of over 100 pages (Business Week Online, 2002). Principles would therefore be easier to comprehend and easier apply to a broad range of transactions.

Harvey Pitt, former SEC chairman, explained how 'because standards are developed based on rules ... they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent'. The use of principles-based accounting standards may provide accounting statements that more accurately reflect a company’s actual performance. Australian Securities and Investments Commission Chair David Knott favours that 'an increase in principles-based accounting standards would reduce manipulations of the rules' (Nationwide News, 2002).

Financial statements that are prepared under accounting standards that clearly state the accounting objectives should benefit users, but they have few, if any, exceptions, and do not include bright-line tests. Heffes (2004), argues that financial statements should be easy to understand, more meaningful and more  informative. She continues by adding that they are likely to result in similar transactions and events being accounted for similarly, and more likely to reflect the economic substance of a transaction, in part, because there will be less opportunity for financial engineering (Heffes, 2004).

However, it could be argued, that a lack of precise guidelines could create unreliable and inconsistent information in the application of standards across organisations, and make it difficult to compare one entity to another. For example, companies are required to recognise both an expense and a liability for a contingent liability that is probable and estimable. On the other hand, a contingent liability that is reasonably possible is only reported in the footnotes. With no precise guidelines, there is no structure to how companies determine if liabilities are probable or only reasonably possible. The lack of bright-light standards would reduce the financial statement’s comparability and consistency. For example, it could be disputed how much income  General Electric actually recognise on a multi-year defence contract under the percentage of completion method of accounting. And whether this is comparable to the income reported by its competitors could also be questioned. Perhaps most importantly, it could called into question whether the auditors, many of whom have been caught behaving badly recently, abuse their trust and fail to apply the principles in 'good faith consistent with the intent and spirit of the standards'.

Principles-based accounting system generally requiress auditors to apply professional judgement to implement and interpret the standards in the absence of sufficient guidances. There is a danger that this method could be used to manipulate financial results. Since they have often set low standards for themselves in this regard (even failing to meet those), it is a big question if they will rise to the occasion.

Advantages and Disadvantages of Rules-based Accounting Standard:

Advantages:

  • Rule-based standards are generally considered easier to audit for compliance purposes, and may produce more consistent and comparable financial reports across entities
  • Requirements are set out in detail and compliance with the rules can be more easily monitored and enforced

Disadvantages:

  • Entities may search for loopholes that meet the literal wording of the standard but violate the intent of the standards
  • 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. It is filled with specific details in an attempt to address as many possible contingencies as possible. This has made standards longer and complicated, and has led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavourable reporting. For instance, 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 evade them (Thompson, 2009).

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