Accounting Standards: rules-based vs principle-based system.

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Advanced Financial Accounting Reporting


There are many methods by which the Accounting Standards are developed. Arguments state that there are two main systems of regulation that defines Accounting Standards which are rules-based system and a principle-based system.

Baxen which is a public listed company uses local accounting standards for their financial reports. The Directors of Baxen are looking to adopt International Financial Reporting Standards for their company. Baxen wants to get involved in trading with many foreign companies and creating trading partners as a subsidiary.

This report will give you a deep understanding of why Baxen should adopt IFRS in their company and also a discussion between rules based and principle-based system. In the recent financial crisis fair value measurement has received its fair share criticism. There are arguments for and against those fair values which are explained in this report.

Accounting systems

A lot of companies prepare their financial statements that are set out by Financial Accounting Standards Board (FASB). Their system is mostly principles-based. In the past there was a lot debate on whether the principles-based is more effective than the rules-based accounting. Reason behind this debate is because of the criticism of the scandals such as Enron and WorldCom.

Rules-based system

When preparing financial statements are many rules to be followed. The rules-based system is basically a list of detailed rules that are followed to prepare the financial statements. A lot of accountants prefer the rules-based standards as if they get brought to court for their judgments of the financial statements were incorrect in their absence they can get away with it. If there are strict rules to prepare a financial statement then this would reduce in errors and also the chances of lawsuits will reduce too. It creates accuracy and reduces error which is good for by management. It can however cause unnecessary complexity in the preparation of financial statements.

Principles-based system

Principles-based accounting is used as a conceptual basis for accountants. Simple objectives are used as guidelines to make sure reporting are done at a high standard. The objectives are explained through giving examples even though they are used as guidance. Some of the rules are still unavoidable which means that guidelines cannot be used for every situation.

The important aspect of principles-based accounting, that their guidelines can be used for variety of circumstances. An advantage of rules based accounting is that if everyone adheres to the same rules that are given, there is less room for interpretation and creative accounting. Detailed requirements can induce managers to manipulate the statements to suit what is compulsory. The disadvantage of having principles-based guidelines is that the information can be unreliable or inconsistent which leads to difficulties when comparing it with other companies. When preparing financial statements it’s always vital of which accounting method is best to use. It must be certain information that is relevant, reliable and also comparable across the reporting periods. A lot of discussion has pushed accountants towards using principle-based system which is important that the method is developed to make it more effective and efficient.

International Financial Reporting Standards (IFRS)

Every country has its own standard of preparing the financial statements. IFRS are a set of accounting standards that have been introduced in 2000 after replacing it with IAS (International Accounting Standards). IFRS is trying to adopt all the countries to use those standards as it can present a better view to foreign competitors or foreign investors to understand and compare it easier. It is also beneficial to individual companies as it can wide spread their business globally as investors would have an understanding of it because it uses the same accounting language. It would be beneficial for Baxen to adopt IFRS as it can support their company growth globally. It can also support them raise capital from aboard as investors would have a better understanding of their company.

Some companies belief that adopting those standards into their companies could outweigh their benefits due to the costs of adopting IFRS but it clear that those are companies who are not thinking of expanding their business globally. If Baxen continued to use local standards and then tried to compare their stance with a foreign competitor, results will be unreliable, as different standards have been used. It is vital to invest to gain more profitable outcome. It’s within the organisation to pull it all together and make sure their financial statements are well prepared and also show beneficial input so foreign investors show keen interest in providing capital.

Fair Value Measurement

In financial reporting one of the approaches companies take is fair value accounting. It measures and reports the ongoing basis certain assets and liabilities. It estimates the prices that it should be sold to relieve of liabilities. This approach is taken place when the company report indicates decrease in assets or increase in liabilities on the basis of their actual or estimated fair market prices. Fair value is a significant measurement as it shows all todays costs of the company. Historical costing method is vital and benefits company more as it takes everything into account over the year. This is done by incorporating information with the cash flows and their current discount rates. Companies are advised to go by prices when market prices have similar positions available. When those markets prices are not available they intend to use valuation models. They also mark down any values of assets or liabilities that show decrease in the market price.

Fair Value measurement limits the company’s ability to manipulate their net income in the financial report. There a many incidents where management purposely create certain asset sales to increase or decrease net income by gaining or loosing sales. The use of Fair value measurement in gains or losses from any price change of a liability or an asset can be figured out immediately as it is reported within the period in which they occur.

Many investors benefit from fair value. This is because companies are required to regularly update their figures on their statement. This is perfect as investors would get fraudulence by companies. This gives a clear picture for investors to analyse whether they should keep investing or not as any losses on assets or increase on liability would be spotted straight away with fair value measurement. It also gives a big picture to new investors to see if the sector is doing well or not.

Some say it is a reliable approach and some say it unreliable. With all approaches there are also disadvantages that occur. Most the value results are created from the analysis that accountants give in. There are lot of human errors that occur during such process and sometimes information could be wrong which leads estimated values being presented incorrect on the financial statement. Sometimes it can occur that human errors are done in purpose to show decrease of liability or increase of assets for companies to maintain a good image as in whole towards other users of their financial statement.

Another major concern that disadvantages fair value is when market prices are not available to compare and ensure fair value. This creates an impact towards calculating an estimate of value which leads to be unreliable approach. It is vital therefore not use the approach to make important final decisions. By measuring these values another important aspect users should think about is that sometimes there can be unforeseeable factors that could affect the estimation of the asset or liability in which the company has nothing to do with.

The credit crunch was a really though financial time which led market prices to be very low at that time. Any measurement of value in that period would have been extremely poor and inconsistent. The recent financial crisis has turned fair value infront of the spotlight which led major policy debating that involved the U.S Congress and the European Commission with banking and accounting regulators from everywhere. Many arguments included that Fair value has contributed a lot to create the financial crisis and worsened a lot of financial institutions. But on the other hand Fair Value has been debating that their neither responsible for the situation and neither is the measurement systems fault as everyone knows that the asset values are reported without including the economic effect of its own.

The market collapsing in the 2008 has nothing to do with fair value. Its job is to value the current mortgage security and compare it with the current market which was really poor at that time. Knowing this they should of approached historical cost or future cost that would of created less damage into the market as it take a lot of measurements and produces a predictable value but it was too late by then. With the support of ICAEW quoting that it is not fair value measurement that occur the financial collapse and everyone should have known about it and that they only measure current situations that occurred at that time.

Substance of Form

There are many requirements

The overriding requirement of a company's financial statements is that they should present a true and fair view, and represent faithfully the underlying transactions and other events that have occurred. To achieve this, transactions are required to be accounted for in terms of their 'substance' or commercial reality rather than their legal form. This principle is introduced in the Accounting Standard Board 'Statement of Principle for Financial Reporting', and also in many standards, in particular Financial Reporting Standard No. 5 (FRS 5), "Reporting the Substance of Transactions" and SSAP 21 'Accounting for Leases and Hire Purchase Contracts'.

To understand the term 'substance over form' (henceforth SOF) properly, this essay firstly describes briefly what is mean by the 'substance' of a transaction and how to determine 'substance'. It secondly explains the importance of SOF. This point is illustrated by analysing an example of the treatment of 'consignment stock' and MicroStrategy case. Thirdly, it discusses some debates over the 'SOF' methodology, and argues it would not be enforced as a standard but used to develop individual and specific standards to deal with particular areas. Finally, it concludes this essay.

Part 1 The Substance of the Transaction

'Substance' can be viewed as the 'reality' or commercial substance of a transaction or an event, whereas 'Form' can be viewed as the strict 'legal' interpretation of a transaction of event.1 Hence, SOF essentially means that it is more important to report in financial statements the economic substance or reality, rather than the legal form.2 i.e. if there is conflict between the substance of a transaction and the legal form of a transaction, the economic substance should take precedence over legal form.3

The substance of transactions should be recorded in financial statements.4 According to the references of FRS 5, a key factor in determining the substance of a transaction is to identify whether it changes the existing assets and liabilities of the company either by creating new ones or altering the existing ones.5 This process requires the consideration of both the legal form and the economic substance of the transaction. The approach to determining the most appropriate treatment is to answer some questions such as, what is the detail of the transaction in the question? What is the legal position? What accounting treatment follows the legal position?

Part 2 The Importance of SOF

Most transactions of most companies are simple and straightforward. They can be assessed easily by the accounting standards, because they naturally coincide with the legal form of the transactions. For example, if an item of stock is sold for cash or on debit the impact on the company's assets and liabilities can easily be assessed.

However, occasionally a company may have a more complex transaction whose substance may not be apparent. The legal form may not appropriately represent the true economic effects of such a transaction. Under this circumstance, the exterior form might reflect high sales, strong profits, good returns and prudent asset management, while the substance reveals insignificant returns or losses, and fraudulent misrepresentation. The two diverge and the choice of how to present the transactions can give very different results. Obviously, to achieve the accountability and transparency in accounting, the principle of SOF is essential.

2.1 The Application: An Example of 'Consignment Stock'

Consignment stock is often found in the motor industry, whereby the stock is held by a dealer but legally owned by a manufacturer. The dealer has the stock on premises, and has the right to sell the stock. However, title to the stock does not pass to the dealer at the time when the stock was delivered. It means that the dealership in fact has not yet bought the stock and so should not yet include the stock, or any liability to pay for it, in its financial statement.

So what treatment should be used for the dealer? Determining if the stock should be classified as an asset of the dealer, involves assessing what the commercial substance of the transaction is. If only the legal form of the transaction was assessed, it might appear that the stock is an asset of the manufacturer.

However, according to FRS 5, the substance of the transaction is determined by assessing where the greatest benefit and risk lies.6 If the manufacturer cannot require the dealer to return the stock, the dealer has no right to return the stock. Consequently, the dealer bears the obsolescence risk and slow movement risk. This indicates that the stock is in substance an asset of the dealer. On the other side of the argument, if the dealer has the legal right to return the unsold stock without incurring an obsolescence risk and a slow movement risk, then the dealer does not have an asset.

Therefore, the substance of transaction should be reflected faithfully in its financial statements not merely the legal form of the transaction, particularly if the legal form of the transaction would present a misleading view of the financial position or results of operations of an entity.7

2.2 What would happen if we instead took 'Form over Substance'?

In fact, fraudulent financial reporting usually involves the presentation of form over substance. A March 1999 report sponsored by the National Commission on Fraudulent Financial Reporting found that more than half of all financial reporting frauds involved overstating revenue. For example, In March 2000, MicroStrategy (MSTR), a worldwide software company, announced that it was revising its financial results. Revenue would be lowered by roughly 25 percent, from $205 million to about $150 million; the problem was caused by recognition of revenue that did not exist. The key question in revenue recognition is this - when is a sale a sale, and when do companies get to recognize the revenues? The answer varies depending on the industry and nature of the revenues. So, it is important that substance (nature) rather than legal form is used to account for a transaction. By recording the substance of transactions, we might reduce the ways in which some companies stretch generally accepted accounting principles to inflate their value.

Part 3 The Debates of the SOF

The evidence presented in the discussion above suggests that the proper reflection of substance over form is essential in order to achieve accountability and transparency in accounting. However there is still much controversy over this issue. Some have discussed that SOF should be used as a guide in setting accounting standards. While others argued 'substance' does not necessarily override 'form', the importance of 'substance' was overrated. This attitude is not supported heavily in the legal profession.8 In the Department of Trade and Industry's statement on the Argyll Foods case, it argued that:

It is axiomatic that any emphasis on substance over form must not be at the expense of compliance with the law.9

So how should we best treat the SOF principle? The accounting bodies in the UK have adopted the view that the important element in any transaction or situation is the commercial substance and not the legal form.10 The documents emerging from ED 42 to FRS 5 in the last few years develop a framework of relevant principles. For example, a set of definitions of the elements of financial statements. These would enable the substance of transactions and other evens to be identified directly. It is likely to be able to successfully deal with new challenges facing financial accounts, including the emergency of new financial instruments and grey leasing. It seems that the principle of SOF has indicators set to be an accounting standard.

But, perhaps the biggest problem of SOF when coupled with the true and fair view, is that it then depends heavily on the accounting profession's ability to interpret sensibly commercial reality, in many different situations, while still following consistent conventions and tenets.

Therefore, the framework of the principle of SOF would not be enforced as a standard but used to develop individual and specific standards to deal with particular areas.11 It would consume far more resources, but would produce treatments that were consistent and respond adequately to novel transaction and other event. Specific standards would also be easier to enforce than general guidance as to the identification of the substance of transaction and other events.12


In conclusion, We have provided the meaning of SOF, and examined the determinants of the substance of transactions. Then, we have explained why the SOF was so important in accounting through a discussion of the treatment of consignment stock. At the same time, we have illustrated how financial statements can be adversely affected if the company emphasises 'Form' of the transactions rather than 'Substance' of the transactions. We have also discussed the debates over SOF, and finally, we have argued how the principle of SOF would be used as a guide in setting accounting standards


Based on my research and analysis’s there is a lot of information in Financial reporting that include varies ways and systems to create a reliable financial statements. It is vital to follow rules based system as it gives reliable information which are