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The early part of this century played host to a number of corporate scandals, such as Enron and WorldCom, which in turn triggered calls for dramatic changes to corporate financial reporting. While financial reporting was not the cause of these corporations' financial problems, it served as a vehicle for managers to disguise financial problems from the public. Individuals raised concerns that financial reporting standards facilitated these frauds by being overly based on detailed rules (SEC, 2003). They argued that the bright-line rules embedded in some financial reporting standards encouraged a form-over-substance approach to financial reporting, and provided the foundation for structuring business arrangements to avoid transparent financial reporting.
Congress responded to concerns regarding rulesbased standards via Section 108(d) of the Sarbanes-
Oxley Act, which directed the United States Securities and Exchange Commission (SEC) to conduct a study on the adoption of a principlesbased accounting system. In July 2003, the SEC released its report, which supported a modified principles-based approach (SEC, 2003). As recently as February 2007, Congress reiterated in H.R. 755 its support for principles-based standards as a route to reducing the complexity of financial reporting. This bill requires the SEC and other standard setting bodies to report annually on their efforts to reduce complexity through the development of principles based standards and other means.
Given the actions of Congress and the SEC over the last 5 years, standard setting in the US will likely continue to shift toward a principles-based approach with less of the rules-based flavor possessed by some current standards.
The paper considers the objectives that might underlie the construction of a concept of standards that are 'principles-based'. It then goes on to look at the explanations of this concept that are given by regulators, professional bodies and accounting academics. It considers whether apparent agreement in explanations actually masks disagreements in the application of the term to accounting standards because the explanations themselves may be variously understood. The paper then considers whether this arises because the concepts used in the 'principles versus rules' debate are 'boundary objects'. It considers whether such concepts are adopted to present the appearance of agreement in concepts where the concept is, in fact, vague. Such concepts facilitate communication between parties with different underlying interests. The paper examines the idea that the concept of 'principles-based' standards may be adopted for political reasons as part of a strategy in the battle for control over global standard setting and as a means of accommodating the interests of lobbyists. It concludes by asking whether a concept of standards being 'principles-based' actually provides a useful 'road map' for standard setters and whether it can support the weight of the convergence project.
For and against accounting standards regulation
Principles- Versus Rules-Based Accounting Standards: The FASB's Standard Setting Strategy (refer again)
Pg2 - Largely because of the Enron Corporation failure, wherein Arthur Andersen was seen as designing or accepting client-originated financial instruments that met the technical requirements of GAAP while violating the intent, the rules-based approach has come under fire. As a direct result of the misleading accounting procedures revealed in the investigations of Enron's failure, the Sarbanes-Oxley Act of 2002 included a provision, Section 108(d), instructing the SEC to conduct an investigation into '[t]he Adoption by the United States Financial Reporting System of a Principles-Based Accounting System'. The SEC's Office of the Chief Accountant, Office of Economic Analysis, issued a 68-page Report (the 'Report') in July 2003 (SEC, 2003). In July 2004, the FASB (2004) responded and in almost all respects agreed with the SEC Report (in part, no doubt, because the Report agreed with an earlier FASB  statement and recommended that the FASB be the sole U.S. standard setter). Therefore, the Report, which summarizes much of the writing on this subject (including submissions by the FASB), provides a point of departure for an analysis of the 'rules vs principles' debate.
Accounting standards are promulgated in order to help to achieve the objectives of financial reporting. These objectives are realized by producing information that meets the objectives of financial reporting and has certain qualitative characteristics set out in the conceptual framework (CF). These include the fundamental qualitative characteristics of relevance and faithful representation and enhancing characteristics such as comparability, verifiability, timeliness and understandability (IASB, 2010). The concept of a kind of standard, that is one that is 'principles-based', is useful if it assists in producing useful financial information that achieves the objectives and characteristics. Identifying the ideal standard is meant to assist in the promulgation of useful standards. As a result of scandals such as Enron it was believed by some interested parties that part of cause of the collapse of the company was that accounting standards were not useful. Instead of the ideal kind of standard 'rules-based' standards predominated. This did not achieve the objectives and qualitative characteristics of useful financial information. The SEC was mandated by the Sarbanes-Oxley Act of 2002 to conduct a study into the approach to standard setting adopted in the U.S. The conclusion of this study was that 'principles-based' or 'objectives-oriented' standards are better than 'rules-based' or 'principles-only' standards (SEC, 2003, p. 4-5).
Characteristics of principles and rules based
Most accounting standards, whether U.S. GAAP or IFRS, are to some extent rules based in that they contain rules for entities to follow when accounting for specific transactions. However, accounting standards vary in their degree of specificity, or ''bright lines,'' such that the more specific standards tend to be classified as rules based while the less specific standards are classified as principles based. The U.S. GAAP lease accounting standard (ASC 840) contains a significant amount of bright-line guidance. Meanwhile, the IFRS lease accounting standard (IAS 17) contains
far less bright-line guidance, requiring accountants to exercise professional judgment in making reporting decisions. Given the SEC's (2003) categorization of accounting standards described above, it seems reasonable to characterize the U.S. standard as rules based and the IFRS standard as principles based.
In the SEC study (2003), the SEC staff "recommends that those involved in the standard-setting process more consistently develop standards on a principles-based or objectives-oriented basis" because standards that have rules-based characteristics "often provide a vehicle for circumventing the intention of the standard." SEC Chairman, Christopher Cox, reiterated this focus in a 2006 congressional hearing. He indicates that the SEC is encouraging the FASB to "develop new standards more consistent with a principles-based, objectives-oriented system."
The Sarbanes-Oxley Act of 2002 required the SEC to conduct a study on the adoption by the United States financial reporting system of a principles-based approach and to submit a report on the results of the study to Congress by July 2003. While the SEC staff was conducting its study, the FASB published a proposal for public comment on a principles-based approach to accounting standard setting. The proposal, issued on 21 October 2002, discusses potential improvement in the quality and transparency of financial reporting under this approach.
The main differences between accounting standards developed under a principles-based approach and existing rules-based standards are summarized as follows (FASB, 2002):
1. The principles would apply more broadly than under existing standards,
thereby providing few, if any, exceptions to the principles, and
2. There would be less interpretive and implementation guidance for applying the
The Sarbanes-Oxley Act required the Securities Exchange Commission (SEC) to conduct a study examining the characteristics of Rules-Based Standards to Principles-Based Standards.
SEC Chairman, Christopher Cox indicates that the SEC is advocating
According to the SEC report,
While the SEC, the Institute of Chartered Accountants of Scotland (ICAS) and most researchers characterize rules as being highly detailed and unambiguously prescribing specific accounting methods (SEC, 2003, I.D.; Kivi et al., 2004, p. 11; ICAS, 2006b, pp. 8, 10; see also Mason and Gibbins, 1991, p. 22), principles are typically described as broad guidelines that, instead of providing detailed implementation guidance, require preparers to exercise judgment in applying the principles to specific transactions and events (Tweedie, 2002, 2005, pp. 33-4, 2007, p. 7; DiPiazza, Jr., 2008, p. 7; Tsakumis et al., 2009, pp. 6-7; see also SEC, 2003, para. I.C.; Psaros, 2007, p. 528).
SEC and some others characterize accounting rules as containing quantitative thresholds (bright-line tests), scope exceptions and inconsistencies, while they consider accounting principles as eschewing exceptions and as being devoid of bright lines (2003, I.C.; see also Bonham et al., 2009, p. 71). Some further note that principles are derived from a complete and internally consistent conceptual framework (Choi and McCarthy, 2003, p. 6; ICAS, 2006a, p. 1; DiPiazza Jr et al., 2008, pp. 4-5; IASB, 2008, P4; Bonham et al., 2009, p. 71).
Rules based standards
several sources including the SEC, the FASB, the Big Four Accounting Firms, and prior literature (Schipper 2003, Nelson 2003, Bartov et al. 2003) to identify the characteristics of rules-based standards; which include: (1) bright-line thresholds, (2) scope and legacy exceptions, (3) large volumes of implementation guidance, and (4) a high level of detail.
Rules-based standards typically provide very detailed guidance with bright-line tests. A perceived benefit of more detailed implementation guidance is greater comparability of financial statements across companies _Schipper 2003_. On the other hand, it has been suggested that rules-based standards lead to a "show me where it says I can't" attitude, which, in turn, can lead to dysfunctional financial reporting behavior _Weil 2002, 3_. Excessively detailed reporting guidance can invite transaction structuring and incentive-consistent standard interpretation to achieve preferred accounting treatments _FASB 2002; Bockus et al. 2003; Nelson 2003_.
rules-based standards contain bright-line rules that make this determination. Detailed implementation guidance typically accompanies these rules. Rules-based standards sometimes include scope exceptions, whereby certain types of arrangements are exempted from the general principles underlying the standard and instead follow special financial reporting treatments. These special treatments typically result in inconsistencies in financial reporting.
Some rules-based standards provide exceptions to general accounting principles; for example, rules designed to avoid volatility in net income. Rules in SFAS No. 87, Employers' Accounting for Pensions (FASB, 1985), smooth the effect on net income of gains and losses related to pension assets and liabilities. Rather than having pension expense reflect these gains and losses as they occur, the standard uses an algorithm that brings a fraction of the cumulative gain and loss into current pension expense
Finally, some managers like rules-based standards precisely for the reasons that have raised red flags about corporate reporting. As noted, bright-line rules can provide a template for structuring business arrangements to achieve desired financial results. A sizeable body of academic research documents that managers engage in financial statement management, and achieve this result in part by transaction structuring (Healy & Wahlen, 1999; Nelson, Elliott, & Tarpley, 2002). In addition to transaction structuring, managers can gain opportunities for financial statement management by lobbying for special treatment for certain types of business arrangements.
Principles based standards
The FASB assessed that to develop principles-based accounting standards a complete, internally consistent and clear conceptual framework is needed. Because
the existing conceptual framework is lacking these qualities, the Board would
need to commit resources to an improvement project. Development of an overall
reporting framework as in IAS 1, with a true and fair view override, was also
The SEC Report urges a principles-based approach that clearly establishes the objectives of an accounting standard. Therefore, to distinguish the SEC Staff's vision of a principles-based approach to standard setting from those proposed by others, they refer to it as objectives-oriented standard setting.
According to the Report, the objectives-oriented standard is based on an improved
and consistently applied conceptual framework and provides sufficient detail and
structure so that the standard can be operationalized and applied on a consistent
basis. The standard, however, should avoid providing too much detail such that
the detail obscures or overrides the objective underlying the standard. Standards
should set out the accounting objective 'at an appropriate level of specificity' with
'an appropriate amount of implementation guidance'. Furthermore, the objectives oriented standard should minimize exceptions from the standard and avoid the
use of percentage tests, known as bright lines. Such bright lines allow for technical
compliance with the standard while evading the intent of the standard.
The Report contrasts the optimal objective-oriented standards not only with
rule-based standards, which are characterized by bright-line tests, multiple exceptions, a high level of detail, and internal inconsistencies, but also with principles only standards. Such standards are defined in the study as high-level standards with little if any operational guidance. A principles-only approach is also rejected because it often provides insufficient guidance to make the standards reliably operational. As a consequence, principles-only standards typically require preparers and auditors to exercise judgment in accounting for transactions and events without providing a sufficient structure to frame that judgment. Consequently,
the result of principles-only standards can be a significant loss of comparability
among reporting entities.
The Report proposes, rather than 'principles-only', what it calls 'objectives oriented' standards, which are said to be optimal as between principles-only and rules-based standards, apparently because they offer a much narrower framework that would limit the scope of professional judgment but allow more flexibility than rules-based standards. 'Objectives-oriented' standards are similar to what the FASB (2004) calls principles-based standards. They appear to be those where the accounting reflects the economic substance of the accounting problem and is consistent with and derived from a coherent conceptual framework, from which there are few exceptions. These standards, the Report asserts, should:
â€¢ Be based on an improved and consistently applied conceptual framework;
â€¢ Clearly state the accounting objective of the standard;
â€¢ Provide sufficient detail and structure so that the standard can be operationalized
and applied on a consistent basis ['Note 1 of the Report says: "In doing so, however,
standard setters must avoid the temptation to provide too much detail (that is, avoid
trying to answer virtually every possible questions within the standard itself) such that
the detail obscures or overrides the objective underlying the standard." '];
â€¢ Minimize exceptions from the standard;
â€¢ Avoid use of percentage tests that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard. (SEC, 2003, p. 5at note 1)
Simply stated, principles based accounting provides a conceptual basis for accounting to follow instead of a list of detailed rules.
Principles-based standards differ from rules based standards primarily through the absence of bright-line rules and exceptions to those rules. In its 2003 report, the SEC (2003) supported a modified principles-based approach, which it termed objectives oriented standards. It characterized objectives-oriented standards as:
being based on a consistently applied conceptual
â€¢clearly stating the accounting objective of the
providing sufficient detail and structure so that
the standard can be operationalized and applied
on a consistent basis
avoiding percentage tests (bright lines) that
allow companies to achieve technical compliance
with the standard while evading the intent (SEC, 2003).
In a 2002 presentation to the Financial Executives International, Robert Herz, Chairman of FASB, explained it as follows:
Under a principles based approach, one starts with laying out the key objectives of good reporting in the subject area and the provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles.
Principles-based accounting standards are typically characterized as containing clear statements of intent but lacking detailed implementation guidance, while rules-based standards are generally characterized as providing greater detail regarding implementation and compliance (SEC 2003).
Why people thought principles is better than rules based
A key concern arising from the recent business scandals is that US accounting standards have become ''rules-based'' filled with specific details in an attempt to address as many potential contingencies as possible. This has made the standards longer and more complex, and had led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavarable reporting. In addition, the quest for bright-line accounting rules has shifted the goal of professional judgement from consideration of the best accounting treatment to concern for parsing the letter of the rule.
To address these concerns, Sarbanes Oxle Act of 2002 required the SEC to examine the feasibility of a principles-based accounting system. The SEC rendered an interesting study that focuses on ''objective oriented'' standards. Accounting firms leaders have supported a move forward priciples based standards. Sam Dipiazza, CEO of PricewaterhouseCoopers, and EdNusbaum, CEO of Grant Thornton, have both publicly proposed a switch to principles based standards. The Financial Accounting Stabdards Committee(FASC) of the American Accounting Association believes that a priciples based approach is more likely to results in transactions that reflect their true economic substance. Finally, FASB Chair Robert Herz has said that the current rules based system is problematic because ''those who want to comply with rules â€¦ are not always sure of everything they need to look at. Those looking to get around the rule â€¦ can use legalistic approaches to try and do it'' (Business Week online, 2002)
Some recent discussions of U.S. financial reporting include implicit or explicit recommendations that the U.S. abandon the current allegedly "rules-based" system in favor of a "principles-based" system, with the implication that some or all ofthe current difficulties facing U.S. financi£tl reporting would be alleviated or even eliminated by such a shift.
(Examples include Joseph Bertirdino, former CEO of Arthur Andersen Worldwide (Business Week, August 12,
2002, page 56); Walter Wriston, former CEO of Citicorp, which is now part of Citigroup (see The Solution to
Accounting Scandals? Simpler Rules," Ttie Wall Street Journal, August 5,2002); Sir David Tweedie, current
chairman of the International Accoimting Standards Board (February 14, 2002, testimony before the U.S.
Senate Committee on Banking, Housing and Urban Affairs); Harvey Pitt, then-chairman of the U.S. SecuritiesExchange Commission (March 21,2002 testimony before the same Senate committee.)
People think principles is better
The Institute of Chartered Accountants in Scotland (ICAS) state that in interviews with professional accountants they found 'almost unanimous agreement for principles-based accounting' (ICAS, 2007, p. 1). ). Both the Securities and Exchange Commission (SEC) and the U.S. Financial Accounting Standards Board (FASB) claim to support the idea of 'principles-based' standards (SEC, 2003; FASB, 2004). The International Accounting Standards Board (IASB) states that its objectives are 'to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based on clearly articulated principles' (IASB, 2011, Â§6).
Schipper argues that U.S. standards are generally based on principles and then discusses advantages of having detailed implementation guidance. Her pragmatic approach recognizes the practical difficulties of implementing principles-based accounting in the United States. She points out that increased emphasis on relevance increases reliance on estimates and that is why the comparability and verifiability are so important.
The Chairman of the FASB believes that in the U.S. many also support a move toward a more principles-based system, feeling that standards have become too complex and too detailed with too many rules emanating from too many bodies (Herz, 2002).
Despite the demand for rules-based standards, the FASB (2002, 2004) and the
SEC (2003) reject them and have turned to proponents of principles-based standards, presumably because in the light of the accounting scandals they consider the costs of rules-based standards to outweigh their benefits. The SEC Report states:
''Unfortunately, experience demonstrates that rules-based standards often provide a
roadmap to avoidance of the accounting objectives inherent in the standards. Internal inconsistencies, exceptions and bright-line tests reward those willing to engineer their way around the intent of the standards. This can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events. In a rules-based system, financial reporting may well come to be seen as an act of compliance rather than an act of communication. Moreover, it can create a cycle of ever increasing complexity, as financial engineering and implementation guidance vie to keep up with one another. (SEC, 2003, at note 13) ''
Perhaps the primary benefit if principles based accounting rest 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 found evidence that mangers purposefully try to structure leases as operating leases to avoid incurring additional liabilities. Providing bright guidelines may improve the representational faithfulness of financial statements.
In addition, 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 ''rule-based accounting standards. FASB Chair Robert Herz has stated that he believes the professionalism of financial statements would be enhanced if accountants are required to utilize their judgement instead of relying on detailed rules.
Another advantage of a principles based system is that it would result in simpler standards. Herz has claimed that a principle 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 be easier to comprehend and apply to a broad range of transactions. Harvey Pitt, former SEC chairman, explained this as follows: ''Because standards are developed based on rules â€¦ they are insufficiently flexible to accommodate future developments in the marketplace. This has result in accounting for unanticipated transactions that is less transparent.''
Finally, the use of principles based accounting standards may provide accounting statements that more accurately reflect a company's actual performance because, as Australian Securities and Investments Commission Chair David Knott has stated, an increase in principles based accounting standards would reduce manipulations of the rules (Nationwide News, 2002).
Conversely, there are potential drawbacks to a principles based approach to standards setting. A lack of precise guidelines could create inconsistencies in the application of standards across organizations. For example, companies are required to recognize both an expense 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, how should companies determine if liabilities are probable or only reasonably possible? The lack of bright light standards may reduce comparability and consistency, a primary precept of financial accounting.
Many accountants seem to prefer rules based standards, possibly because of their concerns about the potential of litigation over their exercise of judgement in the absence of bright-line rules.
Several authors have argued that both U.S. GAAP and IFRS are principles based. Schipper (2003, 62) contends that U.S. GAAP is based on ''a recognizable set of principles derived from the FASB's Conceptual Framework.'' Nelson (2003, 91) states that ''[b]ecause U.S. accounting standards typically are written to operationalize the FASB's underlying conceptual framework, they are based on principles.'' However, he also notes that U.S. GAAP utilizes an ''incremental
perspective'' in which rules added to a standard increase the standard's precision, but also its complexity. Nelson (2003, 91) defines ''rules'' as ''specific criteria, 'bright-line' thresholds, examples, scope restrictions, exceptions, subsequent precedents, implementation guidance, etc.''
While both regimes may be principles based, U.S. GAAP typically incorporates many more rules (Kershaw 2005).
On the other hand, advocates of principles-based standards might argue that differences in reporting result from firms following the intended meaning of the standard. In addition, those favoring IFRS adoption might reasonably
assert that, at least in the case of lease reporting, principles-based standards do not result in the greater dispersion that is anticipated by some (SEC 2003 and Sunder 2009) and dismissed by others (Tweedie 2008).
Principles-based standards, which provide limited interpretive and implementation guidance, are the perceived solution to problems caused by rules-based standards. Less guidance, in theory, increases the need to apply professional judgment consistent with the intent of the standards. Both the FASB _2002_ and the SEC _2003_ believe that this will ultimately result in more meaningful and informative financial statements. (Specifically, the FASB _2002_ concludes that adopting a principles-based approach will result in greater judgment, leading to: accounting treatments that conform to the substance of a transaction, improved transparency, enhanced comparability, increased responsiveness to emerging accounting issues, and facilitation of international financial reporting standard convergence.)
More certain is that a principles-based approach should help users better understand financial statements and use them more effectively in investment and credit decisions. The increased emphasis on the conceptual framework in a principles-based regime should enhance users' understanding of companies' business arrangements, based on their treatment in the financial statements. For example, if a business arrangement gives rise to an asset in the financial statements, the conceptual framework's definition of an asset indicates that the business arrangement provides probable future benefits that the company controls. Moreover, as suggested by Congress, a principles-based approach should reduce the complexity of financial reporting. Users will not need to know detailed rules and exceptions to understand financial statements.
One issue financial statement users face is how to deal with the greater volatility in net income that is likely to arise under principles-based standards. A number of current rules (e.g., pension rules) reduce the effect of factors that increase volatility in net income, through procedures that either smooth the effect of volatile factors or keep these factors out of net income. Principles-based standards will eliminate these rules and allow net income to reflect the natural volatility of companies' business arrangements.
From a user perspective, volatility increases the difficulty of using past financial results to forecast future results, a key judgment for investment decision- making. Thus, while a principles-based approach will reflect volatility as it naturally occurs, it will emphasize to users the difficulty of predicting future firm performance in volatile environments.
Schipper (2003) speculates that lack of specificity in standards could give rise to volatility in reported accounting numbers. Similarly, the SEC (2003), in its study on the adoption of principles based accounting standards, acknowledges and discusses the consistency and comparability problems inherent with both principles-only standards and rules-based standards. The SEC's concerns with principles-only and rules-based accounting standards are expressed as follows (SEC 2003; italics added):
Principles-only standards may present enforcement difficulties because they provide little guidance or structure for exercising professional judgment by preparers and auditors.
Rules-based standards often provide a vehicle for circumventing the intention of the
The expressed concern of the SEC is that either too much guidance in the form of bright-line tests or too little guidance can reduce the usefulness of financial statements to users. In essence, the SEC is saying that rules-based standards tend to emphasize form over substance, leading to poor reporting quality. In contrast, principles-only standards hurt comparability and consistency as interpretations
of the principles vary across time and companies. Niemeier (2008) believes that the lack of specificity makes principles-based standards ''not appropriate for use in a regulatory context. By design, they are of limited enforceability.''
The arguments presented above suggest that different accounting regimes will likely give rise to different accounting outcomes. On the other hand, at least one prominent participant in the debate suggests there will be little difference in accounting outcomes. Specifically, Sir David Tweedie, former chairman of the International Accounting Standards Board (IASB), speaking as chairman in 2008 to an audience in the United States, asserted:
What you have that the rest of the world frankly does not want is a volume of guidance.U.S. GAAP is [over] 25,000 pages. [IFRS are] just over 2,500, yet the results are not faraway from what you have.
critics rules based
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).
Schipper (2003) points out that the U.S. rules are often based on principles. That is, the standard setters use principles in order to produce the rules for the preparers of financial statements. Nelson (2003, 91) agrees, and suggests that a particular standard should rather be seen as more or less rules based. He suggests that rules can increase the accuracy with which standard setters communicate their requirements and can reduce the sort of imprecision that leads to aggressive reporting choices by management. However, he notes that rules can also lead to excessive complexity and to the structuring of transactions
'Rules-based' standards are sometimes favoured because it is suggested that they help to achieve the qualitative characteristic of comparability in financial reporting. Others argue that they do not and argue, as an example, that the 'bright line' tests that distinguish circumstances where pooling of interests was possible and those where it was not result in very different financial reporting for two circumstances which are basically the same (SEC, 2003, p. 18). As Schipper points out 'the desire to achieve comparability and its over-time counterpart, consistency, is the reason to have reporting standards. That isâ€¦similar things are accounted for the same way' (Schipper, 2003, p. 62). At least one objective of inventing a concept of 'principles-based' standards, then, is to create a kind of standard that will better achieve comparability. The characteristics of standards that achieve comparability are used in the definition of 'principles-based' standards. Comparability is one of the 'interests' that underpin the construction of the concept. Other arguments in favour or against different kinds of standards begin with a desire to achieve other qualitative characteristics of useful financial information such as relevance or faithful representation. It has been argued that 'principles-based' standards do not help to achieve these other characteristics even if they do improve comparability (Alexander and Jermakowicz, 2006; Wüstemann and Wüstemann, 2010). This may lead to questioning whether the concept of a particular kind of standard is actually useful in so far as it may not be able to meet all of the desires that prompt its development.
Nelson (2003) and the American Accounting Association.s Financial Accounting Standards Committee (FASC) (2003) review the literature related to these issues. FASC concludes:
Concepts-based standards, if applied properly, better support the FASB.s stated mission of .improving ''the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability''.. (AAA FASC 2003, 74) (emphasis added)
=== The movement toward principles-based standards certainly appears to be on track, with support from Congress, the SEC, the FASB, and the IASB. Whether this movement continues or derails depends on parties inside and outside the financial reporting process. Accountants will have to change the education process to place general principles as the foundation of accounting education. Accountants also will have to learn to manage greater uncertainty in financial reporting judgments and decisions, due to the lack of detailed implementation guidance in principles-based rules.
What problems do standards setters have in promulgating principles based
In Accounting Horizons Schipper (2003) discusses this proposal, in her individual
capacity but as a member of FASB. The bulk of her coverage is summarized in
the first paragraph of her conclusions (p. 71):
In this commentary, I have argued that U.S. financial reporting standards are in general based on principles, derived from the FASB's Conceptual Framework, but they also contain elements-such as scope and treatment exceptions and detailed implementation guidance-that make them also appear to be rules-based.
Principles- Versus Rules-Based Accounting Standards: The FASB's Standard Setting Strategy (refer again)
Two major shortcomings are discussed in subsequent sections. First, the format of standards cannot be discussed and decided on without considering the contents
of what the standard should prescribe. Observing that the FASB follows the asset/liability approach and increasingly adopts fair-value measurements, we argue that the combination of this measurement concept with principles-based standards is inconsistent. 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. We propose to move back from an asset/liability approach with fair values to the traditional revenue/expense model, which is better able to produce trustworthy and auditable numbers.
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 Report therefore examines what it terms 'principles-only' standards, which it defines as 'high-level standards with little if any operational guidance' (at note 13). It then dismisses this alternative, since 'principles-only standards typically require preparers and auditors to exercise judgment in accounting for transactions and events without providing a sufficient structure to frame that judgment. The result of principles-only standards can be a significant loss of comparability among reporting entities' (at note 14). 12 The Report does not further consider whether or to what extent the financial statements of different entities can be more or less meaningfully compared even when based on common rules or principles.
The SEC Report (2003, at note 15) gives two numbered additional concerns that could be ascribed to principles-only standards: '(2) a greater difficulty in seeking remedies against "bad" actor either through enforcement or litigation, and (3) a concern by preparers and auditors that regulatory agencies might not accept "good faith" judgments'. These are not further discussed. However, in a section entitled 'The Role of Judgment in Applying Accounting Standards', the Report appears to dismiss (3), as it states: 'it is simply impossible to fully eliminate professional judgment in the application of accounting standards' (p. 15 at note 21). Nor would we wish to, as we discuss later.
Rather, it offers only two related examples to explain its rejection of principles only standards, impairment of long-lived assets and recording depreciable assets at their historical 'time of acquisition' cost. The Report criticizes the lack of implementation guidance, which leads to a loss of comparability. However, it does not recognize that, no matter how a long-lived asset is initially recorded, comparability is lost as soon as the asset is purchased, as its value in use differs among users. Over time, both value in use and value in exchange or replacement value also change and the alterations will differ among companies; furthermore, the changes often cannot be determined objectively. Consequently, comparability would only be possible if strict rules for revaluing assets at unambiguously specified values were used. It is not 'principles-only' that is at fault here, but the inevitable and, indeed, desirable lack of comparability due to different economic environments. Further, the Report does not recognize that a company's choice of accounting measurement or presentation can convey information that is valuable of investors about the managers' operational and investment approach and decisions.
Other concerns expressed in the SEC Report are that a principles-based approach would result in a loss of comparability and that regulators might not accept 'good faith' professional judgments (SEC, 2003, p. 14 at note 15). In the United Kingdom these problems do not appear to have occurred in any substantial way. Few complaints have been made about the U.K. accounting regime, at least under the ASB. Although the professional press does report some incorrectly applied standards or dubious judgments, these have amounted to only about ten important problems per year among the approximately 1,200 listed companies (excluding technical issues). All this evidence suggests that the principles-based system in the United Kingdom has worked fairly well, partly because even when rules in the form of statements produced by the ASB were instituted, the true and fair view still remained the overriding principle.
We are concerned, however, that standard setters do not seem to take into
sufficient account that the format of standards and their contents are interdependent.
In particular, the more judgment an accounting principle requires, the more
difficult is it to cast it into a standard without plenty of guidance and, perhaps,
exceptions. The FASB continues to permit and may well extend the fair measurement of assets and liabilities even though those valuations are often not based on relevant (applicable) and reliable (objectively determined) market prices. In our view the FASB will have to promulgate very detailed rules governing the permissible inputs to and applications of pricing alternatives even when ostensibly using a principles-based regime. Otherwise, on what basis could auditors challenge
managers' assertions about appraisals, comparable prices and valuation-model
inputs such as expected cash flows, probabilities and relevant discount rates? The
result, we believe, will be a continuation and extension of the present rules-based
accounting standards model, with all its attendant faults. This is an important
reason for our preference for the traditional revenue/expense model, which provides
more trustworthy and auditable procedures than the asset/liability approach
in combination with fair value measurement.
In addition to balancing the advantages and disadvantages of more detailed rules, the standard setters sometimes face competing principles. An obvious example is the difficulty of trading off relevance and reliability: for instance, estimates of current values or future cash flows might be potentially relevant data, but some such estimates have low reliability.
Indeed, much of the debate and criticism about IFRS adoption in the United States revolves around the lack of specificity associated with principles-based standards, with opponents arguing that less guidance and greater judgment will likely result in more diverse interpretations, treatments, and practices.
Sunder (2009, 104) makes the point succinctly:
High-quality standards based on principles instead of rules are supposed to help generate financial reports that are more useful by reason of being more comparable across firms, industries, and countries . . . A general principle is concise and calls for judgment in its application, which must necessarily vary across individuals and situations, giving rise to greater variability in applications than a more detailed rule-presumably calling for less judgment-will generate.
Three primary groups will be affected by the movement to principles-based standards: financial statement preparers, auditors, and users (e.g., investors). As regards preparers and auditors, the primary implications of principles-based standards relate to expert judgment and financial statement misrepresentations. For users of financial statements, important issues involve reliability of financial statements and the extent to which principles based standards affect investors' ability to use financial statements in decision-making.
Acknowledging support for the proposition that 'principles-based' standards are the ideal kind of standards, the ICAS seem mystified by the fact that 'we can't get there' and that standard setters appear to be moving towards 'rules-based' accounting standards rather than embracing 'principles-based' ones (ICAS, 2007, p. 1). A survey of members of ICAS in 2011 revealed that 72% of them believed that International Financial Reporting Standards (IFRS) were very rules dominated and 67% believed that IFRS were more weighted to rules than they were five years ago. They also believed that the financial crisis and the move to convergence with the U.S. would result in more, rather than fewer, rules.
=== The paper has considered why it might be the case that despite widespread agreement amongst standard setters, regulators and those who follow accounting standards that accounting standards should be 'principles-based' there is an apparent difficulty in promulgating such standards or agreeing that the standards formulated are of this kind. It is suggested that one reason for this is that the concept of a standard being 'principles-based' is vague.
The paper argues that the concept of being 'principles-based' does not provide clear direction of the interests of standard setters. The conclusion of the paper is that it would be better to recognize the impotence of such a concept. It is time to 'neutralize the rhetorical and political power of the false binary' and allow a 'fizzling out of the vocabulary altogether' (Cunningham, 2007, p. 1493). The idea of 'principles-based' standards has outlived its 'sell by' date and should be dumped.
The SEC (2003) Report states that the rules-based nature of U.S. GAAP has generated a mass of detailed rules and guidance and bright-line specifications in the standards encouraging financial engineering to meet the letter but not the intent of GAAP, resulting in less informative or misleading financial statements. We agree with this analysis and support the move towards principles-based standards suggested by the SEC and subsequently followed by the FASB's standard setting strategy. Due to the United States' status as lead example for international standard setting, this change in the format of U.S. GAAP has a significant impact also on other countries.
In the end, we agree with the FASB's (2004, p. 6) view that 'a move toward more objectives-oriented standards will require shifts in attitude, behavior, and expertise of preparers and auditors'. Unfortunately, FASB has not suggested measures to bring about such a shift.
I follow Schipper (2003) by starting with the assumption that comparability/consistency in financial reporting is a good thing. I further agree with Schipper (2003) and with Nelson (2003) that rules can help with clarity/comparability. However, this paper argues that some of the rules in existing standards occur because a standard is based on a poor principle or because it lacks principle. Use of a more appropriate principle would reduce the need for arbitrary and detailed rules. That is, the removal of rules can sometimes be associated with increased clarity and comparability. For some topics, use of a better principle would also help in the reduction of optional accounting methods.
I do not mean to imply that a principles-based standard is always better than a rules-based standard, or that concentration on principles will always lead to less complex rules. However, the standards on some topics contain extensive rules and optional accounting methods because of a lack of principle or because of the use of an inappropriate principle not found in the frameworks. In these cases, the standards could be clearer and could lead to greater comparability at the same time as
reducing the rules.
With respect to practice, our results provide insight into the principles-versus-rules debate and should be of interest to U.S. policy makers as they continue to contemplate a switch from rules-based to principles-based accounting standards. Our findings suggest that moving toward more principles-based standards _such as the SEC's proposed adoption of IFRS_ will not necessarily open the door to greater opportunistic reporting by financial statement preparers; instead, this shift could result in more economically meaningful reporting. Also, our results regarding variability in financial statement preparer responses can help allay concerns regarding inter-firm comparability in a principles-based standards regime. Further, in our setting, we find that switching to a more principles-based approach appears to have a greater dampening effect on aggressive reporting than does strengthening the audit committee.
Although there is considerable support for the idea that a financial reporting system should be based upon 'principles-based' standards, progress in achieving this end has been slow.