Recent accounting scandals have raised concerns over the quality and transparency of financial accounting and reporting in the United States. Critics of what is termed the "rules-based" system currently used in the U.S. cite the increasingly detailed

Question

and complex nature of rule-driven accounting pronouncements. These critics suggest that the United States should adopt a principles-based system similar to that of the International Accounting Standards Board. Explain what is meant by a principles-based system and the advantages and disadvantages of such a system.

Answer 1

Under a principles-based approach, the principles developed would apply more broadly than current accounting standards under the rules-based approach. These broad principles would be applicable to a wide variety of situations and would require more professional judgment on the part of both auditors and preparers of financial statements in order to comply with the intent and spirit of the principles. The wider applicability of the principles would result in less need for interpretation and detailed implementation guidance and would be more responsive to emerging issues in the changing financial and economic environment.

A complete, consistent, and clear conceptual framework is absolutely necessary for the development of principles-based system. An overall reporting framework providing guidance on issues such as materiality assessments, going-concern assessments, professional judgments, accounting policies, consistency and presentation of comparative information also is required. A principles-based system also may require a true and fair view override of principles in order to deal with extremely rare circumstances in which management concludes that compliance with a requirement in a principles-based accounting standard would be so misleading that it would conflict with the objectives of financial accounting and reporting.

Accounting standards based on principles would result in an increase in the number of similar transactions and events being accounted for similarly. Principles-based accounting standards should allow participants in the financial reporting process to focus on the substance rather than the form of transactions and events. A rules-based system often results in an emphasis of the form over the substance of transactions and events. Comparability would be enhanced while the detail and complexity of accounting standards would be reduced. Principles that are more broadly applicable would reduce the need for interpretive and implementation guidance for applying accounting standards. There would be no need for interpretations of exceptions to detailed accounting rules nor a need for exceptions to detailed rules to achieve desired accounting results.

A principles-based approach would require a commitment by all involved in the financial reporting process. The FASB would be required to develop a complete, consistent, and clear conceptual framework while resisting pressure from constituents for exceptions to be included both in the conceptual framework and in the principles developed based on the conceptual framework. The absence of exceptions that reduce the volatility of accounting earnings, for example, must be recognized and accepted by preparers, investors, creditors, analysts, and other users of financial information. Historically, the demands for exceptions on the part of the FASB's constituents have been frequent and strong. The FASB's constituency has shown a definite propensity to pressure not only the Board but also the SEC and even Congress for exceptions under the current rules-based system.

The principles-based approach could lead to situations where professional judgments made in good faith could result in different interpretations for similar transactions and events, thus diminishing comparability. This may lead to a demand for interpretative guidance from the FASB regarding the principles. If FASB adheres to a strict interpretation of the concept of principles-based accounting standards and does not provide such guidance, other standard-setting bodies (either existing or to be created) may emerge as providers of implementation guidance. Such guidance may be provided without the due process procedures that have been characteristic of FASB pronouncements.

A principles-based system may be abused by those who do not apply the standards produced under such a system in good faith consistent with the intent and spirit of the standards. Critics of the principles-based approach suggest substituting so-called professional judgment for detailed rules and restrictions will serve to increase rather than diminish accounting abuses as the dishonest take advantage of the absence of specific guidance on what is and is not acceptable.

Critics also suggest that the honest manager or auditor may be hurt more than helped by principles-based system. The detailed guidance provided by the current rules-based system not only provides the SEC with an effective enforcement mechanism but also limits the ability of the SEC to second-guess professional judgments. Critics of the principles-based system suggest that mounting a viable defense when accused of faulty financial reporting will be much more difficult without detailed rules on which to base a judgment. This could result in more frequent and costly litigation against managers and auditors than currently exists under the existing rules-based system.