In the repercussion of the Asian Financial Crisis of 1997 and the corporate accounting scandals such as Enron and WorldCom in the U.S., regulators and standard setters have requested for improved corporate transparency and presented significant changes to accounting standards and regulations. The paper investigates two research questions. First, we consider significant arguments on whether accounting and financial reporting should be regulated through accounting standards. Second, the paper has been examined the idea of what kind of standards should be adopted to regulate accounting and financial reporting. By looking at this, we analyse the characteristics of 'principles-based' and 'rules-based' standards based on …… It then goes on to look at the argument of the agreement on 'principles-based' standards are meant to be more useful than 'rules-based' standards given by regulators, professional bodies and accounting academics. Furthermore, the paper discuss the problems of standard setters have in promulgating principles-based standards. The paper concludes by asking the adoption of accounting standard is worthwhile.
What are the arguments for and against regulations?
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While financial reporting was not the cause of these corporations' financial problems, it served as a vehicle for managers to conceal financial problems from the public. Individuals raised concerns that financial reporting standards enabled these fraud by being overly based on detailed rules (SEC, 2003). They argue 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.
A significant concern results from the corporate accounting scandals such as Enron and Worldcom is that U.S. accounting standards have become rules-based which has made the standards longer and more complex, thus led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavourable reporting. To address these concerns, the U.S. Congress responded to concerns through Sarbanes-Oxley Act, in which required the United States Securities Exchange Commission (SEC) to conduct an investigation into the adoption by the United States Financial Reporting System of a Principles-Based Accounting System. In turn, this legislation has pushed the SEC and FASB to consider reforms designed to inhibit aggressive financial reporting. The conclusion of the study was that 'Principle-Based' standards are better than 'Rules-Based' standards (SEC, 2003).
What are the characteristics of 'principles-based' and 'rules-based' standards?
According to numerous sources including the SEC, FASB, ICAS and majority researchers recognize the rules-based standards characteristically provide high level of detailed implementation guidance with bright-line thresholds, which results of greater comparability of financial statements. The standard include scope and legacy exceptions, which means certain types of arrangements are exempted from the general principles underlying the standard and instead follow special financial reporting treatments which typically result in inconsistencies in financial reporting (Schipper, 2003). It has been suggested that the exceedingly detailed reporting guidance might encourage transaction structuring and incentive consistent standard interpretation to achieve preferred accounting treatments (FASB 2002; Bockus et al. 2003; Nelson 2003). Moreover, it results to a ''show me where it says I can't'' attitude, which in turn lead to dysfunctional financial reporting behaviour. (Weil, 2002)
The characteristics that distinguish treatments between 'rules' and 'principles' are suggested by the characterization of 'principles-based' standards conducted in the SEC Study. In its Report SEC (2003), principles-based standards are characterized as being based on a consistently applied conceptual framework. It further noted that principles providing sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis. By avoiding too much detail and vague or override the objective underlying the standard, the accounting principles clearly stating the accounting objectives of the standard with an appropriate amount of implementation guidance. In addition, the standard is to minimize exceptions and avoid the use of bright-line tests as that allow companies to achieve technical compliance with the standard while evading the intent of the standard (SEC, 2003). ICAS added and identified another characteristic, stated that accounting principles allow for the exercise of judgement (ICAS, 2006).
The FASB believes there are two main differences between principles-based and rules-based standards. First, the principles would apply more broadly than rules-based, in the way that producing few, if any, exceptions to the principles. Second, there would be less informative and implementation guidance in applying the standards. These results would causes greater professional judgement consistent with the intent of the standards (FASB, 2002). SEC (2003) supported the improved principles-based standards, and highlight they are most favourable accounting standards as they provide a constricted framework that would limit the scope of professional judgement, nonetheless allow more flexibility than rules-based standards.
Why are 'principles-based' standards thought to be more useful than 'rules-based' standards?
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SEC expressed the concern of rules-based standards often provide internal inconsistencies, exceptions and bright-line tests which can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events (SEC, 2003). Prior accounting literatures present the major use of principles-based accounting is that its broad guidelines that can be applied to various situations. Shipper (2003) and Nelson (2003) emphasize that broad accounting principles evade the difficulties in relation to accurate requirements that allow contracts to be written specifically to manipulate their intent (Schipper, 2003; Nelson, 2003). They discovered a 1981 study reveals that providing bright guidelines may improve the representational faithfulness and found evidence that managers structure leases as operating leases to avoid incurring additional liabilities.
Unlike rules-based standard, this approach is significantly different from the 'box-ticking' approach. Both SEC (2003) and FASB (2002) believe principles accounting allow accountants to apply professional judgement in assessing the substance of a transaction which will results in more meaningful and informative financial statements. It is strongly supported by FASB Chair, Robert Herz and says the professionalism of financial statements would be enhanced if accountants are required to utilize their judgement instead of relying on detailed rules accounting. (…)
Both the SEC and the U.S. Financial Accounting Standards Board (FASB) claim to support the idea of principles-based standards as rules-based have become excessively complex and detailed with too many rules (SEC, 2003; FASB, 2004).
As suggested by Congress, principles-based accounting would be easier to comprehend financial statements and more effectively in investment and credit decisions. Users will not need to know detailed rules and exceptions to understand financial statements. Herz (……) has claimed that a principles based system would result in simpler standards as it would be less than 12 pages long instead of over 100 pages. The AAA Financial Accounting Standards Committee (2003) expresses principles-based standards have the potential to promote the financial goals of the FASB in ways that rules-based standards cannot, which reflect a more consistent application of the FASB's Conceptual Framework and enhance individual's understanding of the framework.
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 expressed principles based accounting would reduce manipulations of the rules (Nationwide News, 2002). Schipper (2003) asserts that standard setters use principles-based in order to produce the rules for the preparers of financial statements. Nelson (2003) agrees with that and suggests that rules can increase the accuracy of company actual performance with which standard setters communicate their requirements and can reduce the sort of inaccuracy that leads to aggressive reporting choices by management.
It has been argued that principles-based standards uncertain to achieve those characteristics despite the standard do improve comparability (Alexander and Jermakowicz, 2006; Wüstemann and Wüstemann, 2010). This may lead to interrogative on the idea of principles-based is an essential useful in achieving accounting objectives.
What problems do standards setters have in promulgating standards that are 'principles-based'?
Although the suggestion that principles-based standards are the ideal kind of standards, the ICAS expressed the misperception of 'we can't get there' and so standard setters take part in moving towards rules-based standards instead of embracing principles-based standards (ICAS, 2007). A survey from 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.
It was found that there are several major issues that standard setters need to consider in promulgating principles-based standards. There will be a problem when standard setters recognize that principles-based standards are unlikely to meet the objectives of accounting standards. It has been argued that some standard setter may think standards are only promulgated as they will meet the objectives and assume that there would not be a problem, thus required no answer to the problem. SEC contends that 'it is…precisely the role of the standard setter to define the class of transactions included within the economic arrangement and then to establish the appropriate accounting for that class of transaction. While not everyone will agree with the standard setter's conclusions, making the determination of the underlying economics of an agreement and the appropriate accounting for that arrangement are integral to the standard setter's role (SEC, 2003).
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The problems arise when standards setters approach the difficult task of determining the appropriate level of detailed guidance to achieve sufficient comparability and consistency in financial statements. Observing that the FASB follows the asset and liability approach combined with fair values, some 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 for management judgement and encourage manipulation, thus they often cannot be assured by auditors (Benston, Bromwich and Wagenhofer, 2006). As a result, principles-based standards would likely degenerate into providing rules-based standards. Thus, a principle requiring financial instruments to be measured at fair value became a detailed rule with complex stipulations and exceptions that allow corporations to structure contracts to achieve favourable reporting.
The dismissal of true and fair override required companies and auditors to not follow the standard or rule if its application would results in the financial statements not presenting a true and fair view of the company's financial position. As a result, there will be a problem if companies and auditors do not rely on standard setters to avoid the problem of standards that will not always meet the objectives. The SEC (2003) Report indicates that principles-based standards can portray economic arrangements in a way that omits nothing of relevance to investors, creditors and other users, and can specify and effectively deal with how these should be accounted for, but the past rules-based standards suggests that it is an 'impossible dream' (Benston et al., 2006). When companies and auditors seek guidance about how they are to account for a transaction that was not considered by the standard setter, new rules will be established. Therefore, it will give opportunistic managers to produce misleading financial statements that conform to the guidance. As Weil (2002) asserts, managers would continue to say to auditors, 'show me where it says I can't'. In other words, the move away from checklist mentality will required a behavioural change.
Another issue standard setters confront is dealing with greater volatility in net income when different accounting standards may require changes accounting treatment in certain circumstances. If the implementation of principles-based standards implies no scope and treatment exceptions that are intended to smooth income, there would be increased volatility in reported income numbers. Consequently, it would be a dilemma for financial statement users in predicting their future performance of using historical financial results, which reflect a fundamental judgement for investment decision making. The underlying economics volatility will not have shifted, simply because the accounting treatment changes. But to the extent preparers, investors and others prefer accounting treatment that smooth out inherent economic fluctuations, there would be dissatisfaction with principles-based reporting system that eliminates treatment alternatives which exist simply to smooth income. (Schipper, 2003)
The paper has considered why accounting and financial reporting should be regulated and the argument amongst regulators, standard setters and accounting academics corresponding on accounting standard should be principles-based standards. Most of the criticisms on rules-based standards over principles and expressed the standard has generated a mass of detailed rules and guidance and bright-line specifications in the standards, resulting in less informative and misleading financial statements. However, it is not saying that principles-based standards is always better than a rules-based standards, or that concentration on principles will always lead to less complex rules. The paper has deliberated that despite there is considerable support for the idea that a financial reporting system should be based upon principles-based standards, there is an apparent difficulty in promulgating such standards or agreeing that is the ideal standard.
The major concern is that either excessive guidance in the form of bright-line tests or inadequate guidance can affect the usefulness of financial statements to users. The SEC expressed the concern that rules-based standards are likely to results low reporting quality as the standard give emphasize to form over substance. On the other hand, principles-based standards insufficient to achieve comparability and consistency as it required changes accounting treatment in certain circumstances. Niemeier (2008) believes that the lack of requirement causes principles-based standards ''not appropriate for use in a regulatory context. By design, they are of limited enforceability.'' The conclusion of the paper is that different accounting standards will lead to different accounting outcomes.