In this essay, the two different approaches of accounting have been discussed. One approach is being followed by FASB and the other approach is being followed by IASB. These two approaches are Rules - based approach and Principles - based approach. Rules - based approach says that accounting principles and standards should change with the environment, financial conditions, and as new issues arises in the field of accounting. On the other hand, Principles - based approach says that accounting principles and standards should be made according to the already set principles. All the principles are predefined and it works with a set of laid down system. This belief is named as principle - based approach. Further in this essay, these two approaches have been critically analyzed on some selected points. The stances, pros and cons of each approach have been discussed in detail. And based on the analysis, conclusions about the favorable approach or way have been made. An recommendation has also been made in the end that objective approach should be followed which means that instead of following either of these two approaches alone, a mixture of both of these approaches should be followed so that the flaws of each approach could be minimized.
Critical evaluation of rule based and principle based approach in accounting
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There are basically two main standard setting bodies i.e. FASB (Financial Accounting Standard Board) and IASB (International Accounting Standard Board). These standard setting bodies have their own frameworks. Frameworks are used to rephrase current accounting standards and to produce new accounting standards. is generally followed in United States of America whereas IFRS is followed by most of the other countries of the world. Since 2001, more than one hundred countries around the globe have been permitted / required to use IFRS (IASB structure). In addition to these two standard setting bodies, there are also other small and local standard setting bodies present. But IFRS are generally followed by most of the countries especially by big economies. Apart from the "frameworks" there are also other differences as well. One of these differences is the "approach" that each one of them has used to build standards and frameworks. GAAP uses the Rule - based approach whereas IFRS uses the Principles - based approach in building accounting standards.
Each of these approaches has its own pros and cons. The stances of each of these approaches have been discussed and critically analyzed in detail below;
The implication being, that if anyone in the society believes your practices to be fudging the problem, or non-genuine, and immoral then the problem of confidence in your actions id arises. This would then force, and should influence everyone to strive for a high standard of practice, as minimal compliance and standards would not really be tolerated and enough for the standpoint of investors and community. The accountant and auditors have to rely on their judgment, so the more conservative approach they adopt, it would be much better for the investors. So strict rules should be followed and they should try to meet the highest standards rather than minimal.
Following the rules necessitate all members of a society to demonstrate minimum values and standards of practice. The standards have to be in essence meeting the minimally acceptable practice level in order to get approved by a majority of members. Due to minimal required level, the results could be less-than-excellent standards. The rules-based practices also encourage those people to play around with the rules, to find loopholes and ambiguity in the rules, and to figure out ways to make manipulations. This has been evidenced in the last decade in major economics like Canada and the USA by their political leaders as well as famous business leaders and companies (Doug Macnamara & Banff, 2004)
Principles-based approach fundamentally has no minimum standard of practice and they keep on growing over time. Principles-based framework influence a wide set of practices meeting the requirements to a level of expectation by the society at large (McGladrey & Pullen, 2009). Principles promote organizations to adopt straight away raising their current practices in-line with the Principles based approach, striving for continuous improvement over time (Doug Macnamara & Banff, 2004). Principles-based are very useful in allowing firm's to modify their understanding of how to implement business practices of the highest standards for every changing and unique conditions, and operational realities of the industry. This should thus result in better, more appropriate governance actions compared to minimum compliance with a set of basic rules.
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Even though the establishment of financial accounting standards and auditing has conventionally been founded upon a rule-based structure, the theory of a principle-based approach has been from time to time advocated since being incorporated and due to recent high profile scandals in which the financial accountants and auditors have been involved and made massive manipulations do to rule-based ethical standpoint and have failed to protect investors, stakeholders and general public interest raised concerns for the public to still believe on rule-based theory (George J. Benston, Michael Bromwich, Alfered Wagenhofer, 2006).
In Accordance to a commonly view, U.S. accounting standards are more rules-based than principles-based framework. This observation brought in large part from the stress put on two characteristics of the wording of the typical verification statement: 'the financial statements present fairly, in all material respects, the financial position of X Company as of Date, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles' (emphasis added).2 'Present fairly', which indicates a principles-based approach, is basically converted to a rules-based approach when it is 'defined' in SAS 69 (.05 a) by reference to Rule 203 of the AICPA Code of Professional Conduct. This rule states that 'present fairly' "implies that the application of officially established accounting principles almost always results in the fair presentation of financial position, results of operations, and cash flows".4 GAAP is specified by SAS 69, paragraph AU 411, as a hierarchy of conventions, rules and measures propagated by particular authoritative bodies, particularly the Financial Accounting Standards Board and precursor firms (e.g., the Accounting Principles Board).4 Thus, if the itemized and codified GAAP have been followed as specified, most likely the attesting CPAs have done their jobs properly and sufficiently in the eyes of the Securities and Exchange Commission and (probably) the Public Company Accounting Oversight Board (PCAOB). The 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. These events have encouraged principal-based theorists to present and they standpoint which is more ethical and concerned to the investors and stakeholders (George J. Benston, Michael Bromwich and Alfred Wagenhofer, 2006). The rule-based customs of auditing became a trouble-free tool that was responsible for the unethical and immoral conduct of companies like Enron and Arthur Andersen due to which thousands of people lost their every penny in pocket and their homes (David Satava , Cam Caldwell ,Linda Richards, 2006). The accountants and auditors should work to re-establish public confidence and to get enhanced the ethical conduct. Principle-based approach is necessary to significantly change the ethical behavior of the financial reporting and auditing. The accountant and auditors must show a readiness to assess them critically and adopt principle-based approach and show commitment to change firm's culture, if they want to restore their lost credibility and trust with the public. To conduct periodic cultural audits of accounting firms could be effective tool. (Bean and Cunningham, 2004)
The accountants and auditors have moral certain obligations in order to justify with their profession dignity that includes responsibilities, aims, ethics, principals, values and commitments to honor these imposed obligations (Paine, 2003).The auditors must incorporate and integrate both a rule-based evaluation of the financial health of an audited firm and a principle-based assessment of the financial condition of an entity as an ongoing business and as a possible investment opportunity. The basic responsibilities implicit in that task is to combine technical expertise and professionalism necessary to achieve meticulousness, precision in providing enough information to make cent percent sure that transparency regarding the audited firm's financial condition, and completeness, objectiveness and independence in conducting an audit comprehensive to indemnify the integrity of the audit report and hence increased the creditability of the audit firm ethical and professional attitude.
Recent accounting scandals have raised the concern that rule - based approach has become too vulnerable and there is sky-scraping need of principles-based regime. There is a great debate regarding the effectiveness in the Governance world these days about how to improve the level of confidence and trust in our communities concerning the Governance bodies of both for profit and not for profit organizations. While many discussions are taking place, the highest profile ones are playing out in the various global securities communities, with other organizations taking their lead from there. However to some Board members might find these debates and arguments quite detached and isolated from their day-to-day governance duties and responsibilities. This is really important to understanding the different positions and stance in this debate of governance, and the underlying logic and rationales should be considered by the Board to better develop policies and best practices to improve governance & transparency. This would lead to enhance community confidence & trust in your organization's leadership. To have a trust on leadership and the management is one of the most important things for the investor point of view before investing in any company. A fall-out from the continued litany of wrongdoing of our senior leaders and players has exposed in the media, which has led to overall exacerbation & deterioration in confidence and trust of the general public towards those in the privileged position of power and control (Doug Macnamara & Banff, 2004). As each one of these disclosure criticizes into the public's conscience, the trust and buoyancy in Governors and Governance took another massive hit.
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Governors and directors should reflect vigilance and due diligence in their act before selecting any accounting framework and should strive to make sure the transparency and effective control system. The principal based framework has shown its importance over time and raised many questions on rules based system. Governors and directors should use a blend of both Rules and Principles that are relevant to the organization, and formulate and develop new Governance By-Laws, procedures, policies and practices to awake their organization's leadership behavior. We are still encountering more and more conflicts of interest problems at the Governance level and Following the best practices and Self-disclosure of these new practices can improve the society trust in organizations. (George T. Tsakumis, 2009)
After being analyzing the fact and the hard core realities of both the rule-based and principal based approach, it is being concluded that accountants as well as governors should follow the rules based approach because the principal based framework strives for continuous improvement and by following the principal based approach we could attain the highest level of transparency and investors confidence. Due to recent scandals accounting standards are already under severe criticism. The rule based approach has lot of loopholes because it only requires the minimum standards to satisfy it's objectively as compare to principal based approach which keep on setting new standards and milestones. The auditors also have to have to show high standards of ethical practice and should identity the malpractices being done by the management. They should work independently and objectively and should not come under any pressure by management. They work should be meet the objective of the investors and shareholder instead of management. It has also being witnessed that over the years the governance mechanism has not being what it used to be, so that board of directors and governors need to look into the affair of the management and should engage themselves in debates so that they continuous come up and improve the control system and should tighten the check and balances on the management. The system which needs to be now incorporated in the firms should be blend of both rule based and principal based framework (AAA Financial Accounting Standards Committee, 2003). Together both the framework would be a better option for the accounting standards in order to achieve highest ethical standards and best practices. It would also help the accountants to re-gain their lost creditability which they have lost and general public is now reluctant to trust them.
- Bean, L.: 2004, 'Rebates: Do the Big Four Need an Ethics Audit?', Journal of Corporate Accounting and Finance 15(4), 37-40.
- Paine, L. S.: 2003, Value Shift: Why Companies Must Shift Social and Financial Imperatives to Achieve Superior Performance (McGraw-Hill, New York, NY).
- David Satava, Cam Caldwell, Linda Richards (2006), "Ethics and the Auditing Culture: Rethinking the Foundation of Accounting and Auditing". Journal of Business Ethics. Vol. 64, pp. 271-284.
- Doug Macnamara and Banff Executive Leadership Inc. (2004), "Improving Governance Performance Rules - based Vs Principles - based Approaches". Leadership Acumen. Issue no 16.
- George T. Tsakumis (2009), "Principles - based versus Rules - based Accounting Standards: The influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions". Bennett S. Lebow College of Business.
- AAA Financial Accouting Standards Committee (2003), "Evaluating Concepts - Based Vs Rules Based Approaches to Standard Setting". Accounting Horizons, American Accounting Association. Vol. 17, no 1, pp 73-89
- George J. Benston, Michael Bromwich, Alfered Wagenhofer (2006), "Principles - Versus Rules - based Accounting Standards: The FASB's standard setting strategy". Abacus, Accounting Founadation (University of Sydney), Vol. 42, No. 2
- McGladrey & Pullen (2009), "Principles Vs Rules: The Heart of the difference between US GAAP and IFRS". RSM Mcgladrey, Business Consulting. Issue no. 1
- The papers in this forum adopt varying positions regarding this view.
- The FASB's proposed Statement of Financial Accounting Standards, The Hierarchy of Generally Accepted Accounting Principles (FASB, 2005a), would more explicitly codify the rules. It says in para. A5 it expects to 'reduce the number of levels of accounting literature under the GAAP hierarchy to just two ('authoritative and non-authoritative . . . [and] integrate GAAP into a single authoritative codification'). The standards adopted by the FASB would be the first level.
- The AICPA's Auditing Standards Board proposed amendment to SAS 69 (AICPA Auditing Standards Board, 2005) includes this language. Although the statement includes an 'almost always' qualifier, it has not been interpreted to allow for an override.
- If adopted, SAS 69 applied to non-governmental entities would delete the GAAP hierarchy specified, particularly the statement in paragraph .05 a that gives as the first source-'Accounting principles promulgated by a body designated by the AICPA Council to establish such principles'- and .05 b which includes: 'Pronouncements of bodies composed of expert accountants, that deliberate accounting issues in public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted'. These and other sources would be replaced by the FASB, which 'is responsible for identifying the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States' (AICPA Auditing Standards Board, 2005, .08).