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Arguments about the distinctions between principles-based and rules based accounting

Bennett, Bradbury and Pragnell argue that no sensible distinction is to be drawn between principles-based and rules-basedaccounting standards, except in respect of the degree of judgment required for the implementation of each In contrast, Benston, Bromwich and Wagenhofer can

identify such a distinction, arguing for a ‘principles-based approach’ with a ‘true

and fair override' to facilitate the exercise of ‘professional judgment

Alexander and Jermakowicz illustrate that ‘much of the debate . . . is at best vague

and confused, more likely disingenuous, and possibly intellectually dishonest . . .

the basic [SEC] question [is] whether the financial statements perform the function

of enlightenment . . .’

And falling back on the notion that it means whatever

the outcome from complying with the prevailing Standards, it is quite likely that

they will be ‘nailed to the wall’ once ‘true and fair’ is expected to have some sensible

implications. That is the function of the ‘true and fair override’ that Benston et al support.

principle& rule based(US&UK)

U.K. law is based on the duty of a (limited liability) company, regardless of

whether its securities are publicly traded, to its shareholders. Consequently, U.K. accounting and auditing is directed

toward stewardship—providing shareholders with information about the state of resources entrusted to the managers

and directors and how efficiently their company has been run. Emphasis in the U.K. Companies Acts, therefore,

has been on the balance sheet.

In contrast, Bush states that corporate law in the United States is governed by the individual states. Because

of ‘‘a constitutional quirk, the US federal reporting model does not address in enforceable law the fundamental

capitalist proposition ‘do the accounts show how efficiently a company is run on its capital resources?’ ’’ (p. 2).

Instead, U.S. federal securities laws must be and are concerned with securities markets and trades by investors in

those markets. The consequences of this difference are profound, he writes: ‘‘Instead of a commonsense commercial

view of what is relevant accounting and truthful reporting for shareholders, the US regime has become rigid and

rules based’’ (p. 3).

A US perspective on principle based and rule based judgement

A major reason is that fair values require many rules to provide sufficient guidance, they invite manipulation, and they often cannot be assured by auditors.

The second shortcoming is the dismissal of a true-and-fair override that we

argue is a necessary requirement for any standard setting approach. The more

rules the standards include, the more an override provision is necessary to avoid

allowing or even requiring accountants to follow rules by letter but not by

intention. The override gives accountants more professional responsibility for

financial statement content, and its disclosure gives sufficient transparency for

users to understand and, perhaps, challenge its application. We present evidence

on the use of a true-and-fair override from the United Kingdom’s experience

and discuss how International Financial Reporting Standards (IFRSs) cope with

the issue.

The Proposal makes particular mention of FAS 133,

Accounting for

Derivative Instruments and Hedging Activities

, the complexities of which resulted

from the Board having to make numerous exceptions from the general principles

promulgated in FAS 133, para. 3. The extensive guidance, it says, results from

having to fulfill the objectives of comparability and verifiability. The Proposal

rejects ‘principles-only’ standards, because these ‘could lead to situations in which

professional judgments, made in good faith, result in different interpretations for

similar transactions and events, raising concerns about comparability’ (p. 9). Comparability

may be seen as especially important in an international environment, as

there is the danger that local accountants and regulators arrive at differing views

on the interpretation of contentious accounting issues.

Critics on rule based

For these reasons, and based on an example of how corporations (mis)used

the ‘bright lines’ given in APB Opinion No. 16 that specify when a business

combination could be accounted for with the pooling of interests method rather

than the purchase method, the Report concludes that a rules-based system is

not desirable.

Other critics of rules-based standards have pointed out that rules can become

useless and, worse yet, dysfunctional when the economic environment changes or

as managers create innovative transactions around them (Kershaw, 2005, pp. 596–

7). Moreover, such standards need not reduce earnings management and increase

the value relevance of financial reports in so far as the rules increase managers’

ability to structure transactions that meet these rules while violating the intent

(e.g., Nelson

et al.

, 2002) and real earnings management may overcompensate for

judgmental discretion (see Ewert and Wagenhofer, 2005).

The Report therefore examines what it terms ‘principles-only

Twenty questions on International Financial Reporting Standards

By Heidi Tribunella

What Is the Difference Between

Principles-Based Standards and

Rules-Based Standards?

Principles-based standards require

management to apply judgment and expertise

when applying accounting principles.

Rules-based accounting standards, on the

other hand, give strict rules that must be

adhered to in order to properly account for

particular transactions.

For example, lease accounting in the

United States gives four criteria for determining

if a lease is a capital lease. If a

lease contains any of the following, then it

is considered a capital lease and must be

accounted for as such: 1 ) a bargain purehase

option; 2) ownership transfers at the end of

the lease; 3) minimum lease payments

with a present value of at least 90% of the

FMV of the asset; or 4) a lease length of at

least 75% of the economic life of the asset.

This is an example of very specific niles for

accounting for leases. IFRS, because it is

principles-based, does not list specific percentages.

(Question 9 offers a more detailed

discussion of leases.)

The treatment of goodwill was changed

from a rules-based standard, where goodwill

was amortized over 40 years, to a principles-

based standard, where goodwill is

merely tested for impairment and, if

impaired, is written down to its current fair

value (Richard G. Schroeder, Myrtle W.

Clark, and Jack M. Cathey, Financial

Accounting Theory and Analysis: Text and

Cases. 9th edition, Wiley. 2009).

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