Could a principles-based regulatory framework avoid financial scandal


There has been much discussion on the issue of whether a principles-based regulatory framework or a rules-based regulatory framework could avoid corporate financial scandals. It is considered that "the FASB's standards are rules-based and the IASB's standards are principles-based." (Bennett, Bradbury and Prangnell, 2006) According to Alfredson, Leo, Picker, Pacter and Radford (2004), IASB (International Accounting Standards Board) developed the International Financial Reporting Standards (IFRS) from 2001 adopting a principles-based approach. It is also shown in their books that the US Generally Accepted Accounting Principles (GAAP) adopts a rules-based approach. Although some researchers have argued that rules-based accounting standards can protect accounting scandals for the detailed rules cover more aspects during transactions. In my opinion, rules-based accounting standards, which save more costs for establishment and more fair in the regulation process, can avoid accounting scandals more effectively. In this essay, I will first discuss that self-selection rights for companies is a key issue to measure accounting standards. Second, the merits of principles-based standards are shown against views supporters of rules-based standards. Last, an example will be introduced to show the reason why principles-base standards are more appropriate to control accounting scandals.

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Alfredson, Leo, Picker, Pacter and Radford (2004) point that the establishment of financial reports is to reflect the operating, income and cash flows conditions of a firm. Their study also indicate that the information disclosed in the financial reports should be "reliable, relevant and comparable" so that it can help firms to make judgment reasonably. They explained that in the early stages, companies frame corporate reports separately by their own characteristics and it is chaos in the settlement of assets, liabilities and income items. For some companies, they may be motivated to show the better aspects and conceal the worse aspects in their financial reports in order to attract investors (Alfredson, Leo, Picker, Pacter and Radford, 2004). In this case, it is difficult for investors to make sound judgment with those financial statements and this is harmful for the development of the integral economy (FASB , 2002). Therefore, different governments draw up related accounting standards to regulate the account recording and the establishment of financial reports so as to make different corporate reports comparable and reliable for investors to make comparative analysis (FASB, 2002).

However, accounting standards are not absolutely limit the process of the framing of corporate reports. Different companies have distinct features and they belong to various industries with different production and operation methodologies (Palepu, Krishna, Healy and Bernard, 2000). As shown in their research, demanding all companies to adopt the same accounting standards will restrict their corporate individuality and lead to distortions of the information disclosed in those financial statements. Therefore, According to Palepu, Krishna, Healy and Bernard (2000), accounting standards permit corporations to have some certain of self-selection right so that they can choose more suitable patterns to reflect accounting information. As most managers usually tend to show their better operation aspects but cover up the worse aspects, the greater the self-selection right, the more possible of their financial information distortions (Ryan, 2008). In a word, to what extent can self- selection right be given to operators is a key issue.

Principles-based standards formulate the key principles for drawing up excellent financial reports and provide explanations of the objectives of the reports and give some related common cases (Alfredson, Leo, Picker, Pacter and Radford, 2004). However, not all of the possible conditions are included in it. It is demanded that users should follow the guidance of the main principles when there are conflicts between the particular standards and the main principles (Cairns, D., 2001). It is also required that the establishment of financial statements should be "truth and fair overriding" and "substance is more important than format." (FASB, 2002).

Under this circumstance, the operator of the firms should make more specialized judgments. That means more self-selection rights are allowed to them(Ryan, 2008). According to Ryan (2008), auditors should also make their own judgments to investigate whether companies comply with the accounting principles and make their financial statements reasonably. He also points out that the integral process of judgments by the auditors should be transparent and published. As he mentioned, to some extent, this can avoid the distortion phenomenon caused by the self-selection rights given to the operators of the companies. But for the understanding of the accounting principles are different from person to person, it is impossible to avoid the distortion of the information reflected in the financial statements(Ryan, 2008).

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Rules-based standards list rules for all the possible conditions under each standard in particular and require users to draw up financial statements according to these rules (Mason and Gibbins, 1991). Tweediet, D. (2002) stated that the merits of this approach are as follows: First, companies need detailed rules to limit the uncertainty of transactions. Second, auditors also need detailed rules to protect themselves in the process of lawsuits and reduce the disputes with their clients. Finally, these particular rules can help securities supervision departments carry out regulation activities more easily (Tweediet, D., 2002). However, the demerits of rules-based standards are also apparent. Mason and Gibbins (1991) indicate that the detailed rules would reduce the self-selection right of the operators of firms and they are often used or evaded through concoctive plans by companies or individuals for ulterior motivations. Besides, rules-based standards might stimulate companies and chartered accountant pay much attention to those detailed accounting rules rather than the integral truth and fair of the financial statements (Mason and Gibbins, 1991).

In sum, principles-based standards precede rules-based standards. Rules-based standards limit the methodology of accountant recording into a narrower range, which is against the development of corporate operations (Mason and Gibbins, 1991). While under principles-based framework, operators of firms can abide by the main accounting principles and combined their own corporate characteristics to reveal financial information (FASB, 2002). It may be argued that the greater self-selection rights could affect operators choose methods to misrepresent accounting information. But this can be avoided by updated principles during practice. Moreover the flexibility the principles-based standards owned is much more suitable for the multiformity of modern corporate operation (Healy, P. and Palepu, K., 2003). Subsequently, under the rules-based framework, the setting of accounting standards is lagging the development of transaction forms (FASB, 2002). As shown by Bennett, Bradbury and Prangnell (2006), this may lead to some circumstances under which there are no rules can be complied with. Meanwhile, they also indicate that it is easier for the dealers to evade detailed rules than main principles through special operations. Principles-based standards value greater on the substance of transactions, the judgment on the truth and fair of transactions is not modified as the change of the transaction forms (FASB,2002). This could ensure the accuracy of the accounting information reflected.

The case of Enron can be analyzed to support principles-based standards in the protection of accounting scandals. Special purpose entities (SPE) are important tools for Enron to use for financing. (Healy, P. and Palepu, K., 2003). They also indicate that SPE is an entity established by the sponsor so as to achieve special operation activities, such as leases and capital securitization and SPE is an off balance-sheet financing entity. Under GAAP, there are many circumstances that the sponsors and the beneficiaries have closed relationship but SPE is not included to the convergence of financial statements (Lieberman and Thompson, 2002). Thus, the convergence of SPE is becoming more and more important to be considered during the establishment of financial reports to avoid accounting scandals.

All in all, principles-based standards can limit accounting scandals more effectively than rules-based standards. As David weediet (2007) said that the convergence of IFRS and US GAAP could promote the international accounting regulation and the management of global capitalization. To combine the two accounting standards is a prospective topic for us to explore in the protection of accounting scandals in the future.