The primary advantage of principles-based accounting rests in its broad guidelines that can be applied to numerous situations. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent.
A 1981 study sponsored by FASB found evidence that managers purposefully try to structure leases as operating leases to avoid incurring additional liabilities. Providing broad guidelines may improve the representational faithfulness of financial statements.
Principles-based accounting standards allow accountants to apply professional judgement in assessing the substance of a transaction. This approach is substantially different from the underlying “box-ticking” approach common in rules-based accounting standards.
FASB Chair Robert Herz has stated that he believes the professionalism of financial statements would be enhanced if accountants are required to utilize their judgment instead of relying on detailed rules.
A principles-based system would result in simpler standards. Herz has claimed that a principles-based system would lead to standards that would be less than 12 pages long, instead of over 100 pages (BusinessWeekÂ online, 2002). Principles would be easier to comprehend and apply to a broad range of transactions.
Harvey Pitt, former SEC chairman, explained this as follows: “Because standards are developed based on rules … they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent.”
The use of principles-based accounting standards may provide accounting statements that more accurately reflect a company’s actual performance. It can be proved by the statement made by Australian Securities and Investments Commission Chair David Knott – “an increase in principles-based accounting standards would reduce manipulations of the rules” (Nationwide News, 2002).
Financial statements that are prepared under accounting standards that clearly state the accounting objectives, have few, if any, exceptions, and do not include bright-line tests should benefit users. They should be easier to understand, more meaningful and informative, are likely to result in similar transactions and events being accounted for similarly, and more likely to reflect the economic substance of a transaction, in part, because there will be less opportunity for financial engineering. (Heffes, Ellen M ,2004) http://www.allbusiness.com/accounting/258377-1.html
A lack of precise guidelines could create unreliable and inconsistent information in the application of standards across organizations and make it difficult to compare one entity to another. For example, companies are required to recognize both an expense and a liability for a contingent liability that is probable and estimable. On the other hand, a contingent liability that is reasonably possible is only reported in the footnotes. With no precise guidelines, how should companies determine if liabilities are probable or only reasonably possible? The lack of bright-light standards would reduce the financial statement’s comparability and consistency.
For example, how much income willÂ General ElectricÂ actually recognize on a multiyear defense contract under the percentage of completion method of accounting? Will this be comparable to the income reported by its competitors? And most importantly, will the auditors, many of whom have been caught behaving badly recently, abuse their trust and fail to apply the principles in “good faith consistent with the intent and spirit of the standards.”
Principles-based accounting system generally requires preparers and auditors to apply professional judgment to implement and interpret the standards in the absence of sufficient guidance to exercise that judgment. There is a danger because they can be used to manipulate financial results. Since they have often set low standards for themselves in this regard (even failing to meet those), it is a big question if they will rise to the occasion.
Advantages and Disadvantages of Rules-based Accounting Standard:
- Rule-based standards are generally considered easier to audit for compliance purposes, and may produce more consistent and comparable financial reports across entities.
- Requirements are set out in detail and compliance with the rules can be more easily monitored and enforced.
Entities may search for loopholes that meet the literal wording of the standard but violate the intent of the standards.
Rules-based accounting has not worked in practice. Critics argue that the present U.S. system does not produce accurate reporting. It focuses on “checking the boxes” more than portraying an underlying economic reality. It filled with specific details in an attempt to address as many possible contingencies as possible. This has made standards longer and complicated, and has led to arbitrary criteria for accounting treatments that allows companies to structure transactions to circumvent unfavourable reporting.
For instance, lease accounting contains hundreds of pages of rules and interpretations while almost no leased assets appear on corporate balance sheets. The system has created an industry of financial engineering and structured transactions designed to circumvent the rules. Many believe that rules closing structuring loopholes will only result in more elaborate ways to evade them. (Raymond Thompson, 2009) http://www.picpa.org/Content/40856.aspx