Rule Base and Principle Base Accounting Standard
Introduction
The parade of corporate accounting scandals of the last decade, with lion’s share occurring in 2002, has developed deep antipathy and distrust towards corporations and their reporting practices, and casted doubts on the opinions of audit firms. As majority of these accounting frauds occurred in the US (See Appendix), there was a widely-held view that rules-based accounting standards have allowed failure of large corporations like Enron and World Com, since US GAAP is perceived to emphasize on the rules-based approach to standards setting. This in its turn has put enormous pressure towards the US regulators and standard setters to relook into roots of accounting standards to regain public confidence and investor trust in the financial markets (Lev, 2012).
The first major regulatory response was Sarbanes-Oxley Act of 2002 (Sarbox), which sparked a hot debate between rules-based versus principles-based accounting standard supporters. In this paper, we shall distinguish between these approaches and provide synthesis of arguments supporting each approach from the existing literature. Based on these explanations, we conclude that choice between rules and principles based approach can be difficult, give some view on dual classification of approaches to standard setting.
Defining and Distinguishing Rules and Principles
Although US GAAP are generally considered to be rules-based and International Financial Reporting Standards are claimed to be based on principles and require professional judgment (Schipper, 2003), the distinction between rules-based and principles-based standards is not well defined and can be variedly interpreted (Bennett et al, 2006). The clarifications on the meaning of rules and principles and their dissimilar features can be found in the legal and accounting literature. The definitions in the legal literature are important stepping stone for more complex and industry-specific definitions in the internal realm of accounting
The parade of corporate accounting scandals of the last decade, with lion’s share occurring in 2002, has developed deep antipathy and distrust towards corporations and their reporting practices, and casted doubts on the opinions of audit firms. As majority of these accounting frauds occurred in the US (See Appendix), there was a widely-held view that rules-based accounting standards have allowed failure of large corporations like Enron and World Com, since US GAAP is perceived to emphasize on the rules-based approach to standards setting. This in its turn has put enormous pressure towards the US regulators and standard setters to relook into roots of accounting standards to regain public confidence and investor trust in the financial markets (Lev, 2012).
The first major regulatory response was Sarbanes-Oxley Act of 2002 (Sarbox), which sparked a hot debate between rules-based versus principles-based accounting standard supporters. In this paper, we shall distinguish between these approaches and provide synthesis of arguments supporting each approach from the existing literature. Based on these explanations, we conclude that choice between rules and principles based approach can be difficult, give some view on dual classification of approaches to standard setting.
Defining and Distinguishing Rules and Principles
Although US GAAP are generally considered to be rules-based and International Financial Reporting Standards are claimed to be based on principles and require professional judgment (Schipper, 2003), the distinction between rules-based and principles-based standards is not well defined and can be variedly interpreted (Bennett et al, 2006). The clarifications on the meaning of rules and principles and their dissimilar features can be found in the legal and accounting literature. The definitions in the legal literature are important stepping stone for more complex and industry-specific definitions in the internal realm of accounting
References: Beechy, (2005), ‘Accounting Standards: Rules, Principles, or Wild Guesses?’, Canadian Perspectives on Accounting, Vol. 4, No. 2, 2005. Bonham (2009), International GAAP 2009, JohnWiley & Sons Braithwaite, (2002), Rules and Principles: A Theory of Legal Certainty, Australian Journal of Legal Philosophy, Volume 27, 2002 Choi and McCarthy (2003), FASB Proposes Principles-Based Approach to US Standard Setting, Bank Accounting and Finance, February 2003. Ewert and Wagenhofer (2005), Economic Effects of Tightening Accounting Standards to Restrict Earnings Management, The Accounting Review. Forbes (2002) The Corporate Scandal Sheet, http://www.forbes.com/2002/07/25/accountingtracker.html, Last accessed: 1 April 2012 Guenther, D (2005), Financial Reporting and Analysis, McGraw-Hill. Kivi, et al (2004), Principles-Based Standards and the Determination of Control for Consolidation, CPA Journal, May 2004. Krahnen and R. H. Schmidt (2004), The German Financial System, Oxford University Press. Nelson, et al. (2002). Evidence from auditors about managers and auditors earnings-management decisions. The Accounting Review, Vol. 77 Ng, M (2004), The Future of Standards Setting, CPA Journal, January. Psaros, (2007), Do Principles-Based Accounting Standards Lead to Biased Financial Reporting? An Australian Experiment, Accounting and Finance, September 2007. Schipper, K. (2003), ‘Principles-Based Accounting Standards’, Accounting Horizons, March 2003. Shortridge and Myring (2004) Defining Principles-Based Accounting Standards, Available from: http://www.nysscpa.org/cpajournal/2004/804/essentials/p34.htm, Last accessed: 16 April 2012 Wüstemann, J. and Wüstemann, S. (2010) Why Consistency of Accounting Standards Matters: A Contribution to the Rules-Versus-Principles Debate in Financial Reporting, ABACUS, Vol. 46, No. 1, 2010 Appendix Parmalat | 2003 | Italy | Wharton (2012) | AIG | 2004 | United States | Wharton (2012) | Lehman Brothers | 2009 | United States | Wharton (2012) | Olympus Corporation | 2011 | Japan | Wharton (2012) | Source: Forbes (2002), Wharton (2012)