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(Benston p.2) 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. Given this degree of unanimity and the reasonable presumption that the Commission approved the Report, its analyses and recommendations should be taken very seriously.
Failure of Enron Corporation raised question on accounting standard and on its reliability. This lead to the debate of 'rules versus principle' based accounting which is centrally located in section 108 of the Sarbanes- Oxley Act of 2002 (2006, p1). This have its own advantages and disadvantages on different aspects. I will take investor as a base to judge which type of accounting is more suitable for investor. Investor look for accounting standards which represent fair representation of accounts which can be enforced for its reliability, should not be complex and overloaded. Standard should represent economic reality and consistency and should discourage creative accounting.
Ng 33 survey reported that principle based accounting is based on professional judgement by accountants and auditors which leads to more fair representation of accounts in both transaction and financial reporting. This makes accounting more clear and represent its fair effect on account, as per accounting experts (p. 9). On the other hand rule based accounting based on broad rules, which focuses on a 'check- the- box' mentality that inhibits transparency. It make it difficult for auditors to take step back and check whether the overall impact of the transaction is consistent with the 'objective of the standards' or not. (Robert Herdman speech in p.9).(Research 34, p.9) also finds out that rule based approach does not cover every situation which arises from new business activities and in contrast principle based can analysed new transaction or event within the broad principles without the need to revise them. on Negative side of principle based accounting commissioner Glassman in (2006, p.27) point out a caution that judgemental reporting may lead to 'bad choice', commissioner agrees that it could be because of management intention to deceive accounting information but it can be possible because of even choices that were technically permissible under GAAP but could be misleading to investors.
Investor requires standard which represent fair account and can be enforceable for its argument. SEC in its 2003 study (2006, p.10) noted a concern that principle based standard may face problem in justifying a transaction effect based on judgement. On the other hand rule based accounting can be easily protected against any lawsuit by addressing the accepted rule. Scipper(2003, p.8) points out that rules are likely to propagate as accountants ask for guidance that, they hope, will protect them from critisicm and lawsuits. (sec 2.3.2 p.10). But the survey reported by Ng 42 included view that difficulty in protect against lawsuit principle based standard would require more accountability from accountant and auditors of the financial statement. (Sec 2.3.1, p.10)on other hand easy enforceability of rule based accounting on support of back up rule may lead to false representation of financial statement. (2.3.1, p.10)
Complex and overloaded accounting often creates problem for its user. FASB which based on rule based accounting acknowledge its limitation of being complex, overloaded and delay (sec 2.5, p.11). SEC commissioner Glassman in (2006, p.30) presents a statistics which shows the complexity of rule based accounting. Statistics shows that eleven rules take more than one thousand pages and over a quarter- million words which takes more than twenty seven hundred man hour worth of meeting. This make rule based accounting very complex and time taking process which often make it hard to implement and cope with changing business environment. Further Glassman while addressing the exchequer club59, p12) criticise rules on complexity by saying 'general accepted accounting principles seems to have become an end unto itself, rather than a means of providing useful information to investor and other end- users'. That is, complexity of rule based accounting restricts itself from providing useful information to its user. (Bennett et al. 2006, p.3) adding to the complex nature of rule by saying that rule based accounting contains numerous bright line tests, exception and too detailed implementation guidance but at same time does not provide any evidence for this claim. On other hand principle based accounting, relies on broad principle which are precise in nature just providing guideline for accounting this make it less detailed and would be easier to comprehend and apply to a broad range of transactions (2.5.1, p.12). Ng55 (p.12) survey also conclude that 'principle based approach would reduce volume of GAAP the accountants would be required to keep up with'. That is, it will reduce the complexity of GAAP accounting standard. But Schipper(2003, p.7) reason for complexity of rules make it more obvious to use it. He says that rules are complex because they include accounting rule for some excluded items (scope exception) or items that received special treatment (treatment exception), which requires a detailed explanation and hence add to the complexity of rules.
Accounting standards should represent economic reality as it :
Kevi et al (2004, in 2006, p.15) regarded principle based accounting as the most suitable standard to represent economic reality. They also added that 'principle based standard are more responsive to changes in business practice and will improve transparency of reporting, and principle based standard make it easier for preparer and the auditor to see the big picture. Ng (2004, 2006, p.15) present the view that rule based had represented economic substance in many occasions.
Comparability and consistency of financial standard facilitate investor to gather useful information about company's financial performance with comparing it with last year report or with another company. Robert H Herz, FASB Chairman (2006, p.20), stated that 'principle based accounting reduce comparability of financial information and leave too much room for judgement by companies and auditors'. That is principle based accounting required professional judgement which may lead to different interpretation of same accounting statement. This is supported by the survey reported by Ng(2.4.2, p.11) which state that principle based accounting lack in precise guidelines that creates inconsistencies in the application of standards. On the other hand rule based accounting often used to improve comparability and consistency (2.4..2, p.11). rule based accounting use predefined rules to do accounting which provide consistency and comparability in its use.
Creative accounting is often a point of concern for standard makers and users of financial statements. Rule based accounting promotes creative accounting by diverting judgement from economic substance to the detail of application (i.e.) (sec 2.6.1, p.13). schipper (2003) says rule based bright line test provide a roadmap for those who intend to comply with the letter but not the sprit of rules', i.e. rules does not have its strength to protect creative accounting. On the other hand Shortridge and Myring (2004, 2006, p.13) favour principle- based- accounting standard as it may provide more accurate accounting statement and will reflect company's actual performance. Ng (2004, 2006, p.14) in his survey state that, respondent to their survey agrees with rule based inability to protect misrepresentation of economic substance, but at the same time they also disagree with the fact that principle based would give better results in representing economic reality in the financial statements. Jackson (2004,p.58, 2006, p.14) finds out that principle based users can twist or spin the presentation to emphasise what they wanted by moulding the economic reality. Nelson et al. (2002, 2006, p.13) from his survey conclude that mangers finds a way for their earning if it is their intention inspite of using any accounting standard method
(2006, p.21), state that European commission adopt principle based accounting because rule based accounting is to complex (i.e. about ten thousand pages of accounting rules) and fails to incorporate fast economic changes and therefore fails to represent true financial position. On contrast principle based approach reflect economic reality and give true and fair view of financial position and performance of a company. This protest the long term interest of investors and other stakeholders.
(principle to objective p.25) (p.56)(p.59)(60)
Need for convergence:-
Nobes (2005, p.1) in his study finds out that rules are derived from principles and only unsuitable principles creates a need for rules. He pointed out six example (leasing, employee benefits, financial assets, government grants, subsidiaries and equity accounting) of standard which are rule based either because they lack principles or they were based on unsuitable principles. Like for leasing which is based on principle of 'transfer of substantially all risks and rewards', which contains no numerical or technical rule surrounding it which make it less practical. To make it more practical Nobes proposed the improvement of applying principle based on the definition of assets and liability which make it more practicle. (Nobes 2005, p.3).
SEC commissioner Glassman (2006, p.28, sec, 3.3) says that personally he did not think either principle or rule based accounting is strongly feasible, and suggested to have a combination of principle and rule. (Bennett et al., 2006, p.10) adding to this discussion says in reality pure principle based standard does not exist. And rules are needed to either clarify the conceptual framework or to stop potential accounting abuse. Benston (2006, p.8) also argue against individual acceptance of principle based accounting, by addressing principle based limitation on asset/liability approach, he says principle require accountants judgement, but it is not always possible without using rule based standard.
Convergence in 2002 Robert Heardman in his speech on convergence (2006, p.54) stated that there is a need to adopt standard which can fulfil global need. US rule based GAAP is controlled by a group of technical experts and is a culture or country based approach. On contrast principle based accounting can be a solution for it but its judgemental analysis raised an issue in its practice which can lead to different interpretation not only by professional from different countries but also from different audit firms. Sir David Tweedie (2006, p.56) complimenting SEC and FASB on their initiative towards a more principle based approach added that principle based accounting is the intense desire internationally and to reduce the complexity of US rule based accounting. Principle will help in reducing the complexity of US rule based standard and improve accounting in general. But at same there is a need to have some explanatory guidance for principle based. And further that to promote international convergence 'we are determined to focus on crafting principles that are sufficiently clear to make detailed rules unnecessary. in 2002 the global head of PwC, Sam DiPazza (2006, p.56) suggested to have a 'principle based global GAAP' and rejected US rule based model. He supported this by saying that 'principle based approach, exemplified by UK GAAP and International Accounting Standard, was the best foundation for making financial reporting more relevant to investor'. That means looking for standard which will allow investor to compare the performance of any company in any industry with any other in any country of the world.