Principal vs Rule Based Accounting
An Insight on IFRS versus U.S GAAP & Implications of IFRS adoption on Financial Statement and Accounting Quality
Q2) Principle and rule-based accounting reflect different approaches to accounting. The pros and cons of rule-based accounting (RBA) and principle-based accounting (PBA) are as discussed. (1) RBA deters creative accounting as rules reduce opportunistic discretion unlike PBA which is more subjective and ambiguous.On the other hand, others argue that rules are a means to circumvent the objectives of a standard and more vulnerable to transaction restructuring. Principles leave less room for preparers to justify “inappropriate” interpretations of standards, thereby reducing creative accounting. (2) The complicated accounting rules used under RBA is too onerous, creating problems for users, preparers and setters alike. In seeking compliance with rules, users tend to lose focus on the spirit of the standard and objectives of fair presentation. Principles are simpler, focused on objectives and hence user-friendly to the masses. (3) It is said that rules provide greater comparability due to application of consistent rules on events and transactions. Furthermore, Sunder’s article argues that IFRS’s principle-based approach introduces more judgement, “giving rise to greater variability in application than a more detailed rule”. However, comparability can be enhanced under PBA if more disclosures are made on key judgements made. (4) Due to its authoritative and prescriptive nature, rule-based standards lower ambiguity and hence, tend to lower litigation risks for auditors and preparers. PBA involves greater judgement and discretion, hence increasing their exposure to litigation risk. Increased documentation may mitigate such risks though. (5) RBA is desired by preparers and auditors as it provides detailed guidance and ‘black-and-white’ solutions to ambiguous issues. This results in deterioration of quality of the accounting profession. Conversely, PBA
Q2) Principle and rule-based accounting reflect different approaches to accounting. The pros and cons of rule-based accounting (RBA) and principle-based accounting (PBA) are as discussed. (1) RBA deters creative accounting as rules reduce opportunistic discretion unlike PBA which is more subjective and ambiguous.On the other hand, others argue that rules are a means to circumvent the objectives of a standard and more vulnerable to transaction restructuring. Principles leave less room for preparers to justify “inappropriate” interpretations of standards, thereby reducing creative accounting. (2) The complicated accounting rules used under RBA is too onerous, creating problems for users, preparers and setters alike. In seeking compliance with rules, users tend to lose focus on the spirit of the standard and objectives of fair presentation. Principles are simpler, focused on objectives and hence user-friendly to the masses. (3) It is said that rules provide greater comparability due to application of consistent rules on events and transactions. Furthermore, Sunder’s article argues that IFRS’s principle-based approach introduces more judgement, “giving rise to greater variability in application than a more detailed rule”. However, comparability can be enhanced under PBA if more disclosures are made on key judgements made. (4) Due to its authoritative and prescriptive nature, rule-based standards lower ambiguity and hence, tend to lower litigation risks for auditors and preparers. PBA involves greater judgement and discretion, hence increasing their exposure to litigation risk. Increased documentation may mitigate such risks though. (5) RBA is desired by preparers and auditors as it provides detailed guidance and ‘black-and-white’ solutions to ambiguous issues. This results in deterioration of quality of the accounting profession. Conversely, PBA
References: 1. Sunder, S. (2009). IFRS and the Accounting Consensus. Accounting Horizons 2009, Vol. 23 (1) pp. 101-111 2 3. Crovitz, L. (2008). Information Age: Closing the Information GAAP. The Wall Street Journal 4 5. Henry, D. (2008) A Better Way To Keep The Books? The U.S. wants to adopt simpler accounting rules used by other countries. But there could be problems. Business Week 6 7. IAS Plus. (2008). IFRS & US GAAP: A pocket comparison. Retrieved www.iasplus.com/dttpubs/0809ifrsusgaap.pdf 8 9. Webster, E., and D. B. Thornton. 2004. Earnings quality under rules- vs. principles-based accounting standards: A test of the Skinner hypothesis. Working paper, Queen’s University. 12. The Institute of Chartered Accountants of Scotland. (2006). Principles not Rules: A Question of Judgement. Technical Policy Board of ICAS.