Principles-Based Accounting as an Accounting Method - Essay Example

? Finance and Accounting Principles Based Accounting Standards By s Due Principles based accounting is an accounting method which is used as a conceptual basis by accountants. To ensure good reporting, this method sets out a simple set of key objectives. In other words, principle-based standards mean moving away from reliance on detailed, prescriptive rules and relying more on high-level, broadly stated rules or Principles to set the standards by which regulated firms must conduct business (Black et al, 2007). This system follows principles. The term “principles” can be used simply to refer to general rules, or also to suggest that these rules are implicitly higher in the implicit or explicit hierarchy of norms than more detailed rules: they express the fundamental obligations that all should observe (Black et al, 2007). Some of the rules set out are mandatory to follow but many other rules are used as a mere guidance and are not applicable to every situation. For instance, many countries have adopted the International Financial Reporting Standards governed by the IASB. According to Securities and Exchange Commission of US, “…the optimal principles-based accounting standard involves a concise statement of substantive accounting principle where the accounting objective has been incorporated as an integral part of the standard and where few, if any, exceptions or internal inconsistencies are included in the standard” (2002). Rule-based accounting is a set of detailed rules which must be followed when financial statements are prepared. An example of such system is Generally Accepted Accounting Principles (GAAP). In US, GAAP is used as a standard framework of guidelines for financial accounting. CPA firms and corporations in US prepare and present their business incomes and expenses, assets and liabilities in their financial statements following GAAP. This system is less flexible and the room to exercise professional judgment is limited. Accountants have to “go by the book” in many cases which can result in inefficient reporting. IFRSs claim to create convergence by standardizing the accounting methods. One of the basic arguments in favor of the rule-based accounting is that this system brings harmony in accounting practice all over the globe increasing comparability. The financial statements are prepared for the users who have reasonable knowledge of business, accounting and economic activities and a willingness to study the financial statements (IASB Framework, Para 25). The users of financial statements are of various types and their needs are different which are required to be catered efficiently because they have to make crucial economic decisions on the basis of financial statements. IFRS requires the financial statements to present a “true and fair view” of the financial state and economic activities of an entity. When a set of given rules is followed uniformly by all the entities in each financial year, comparability increases. A user may compare an entity’s financial standing with that of another entity or even with that of its own in the preceding years. In order to attain this uniformity, the rules are required to be followed but there are cases where following the rules becomes very difficult. For instance, the IFRS itself admits in the Framework that there is a trade-off between relevance and reliability. One must be forgone to avail the benefit of another. In a given case, preferring relevance over reliability might be useful for specific set of users but might not be useful for another set of users. The Framework has emphasized that the preparer or auditor of financial statements must exercise his professional judgment in such cases so that the information becomes more synchronized with the objectives of IFRS. One of the worst economic crises in history has been faced by the world recently. There are many studies and professional opinions that the fair value system is responsible for it. This system is more relevant to the users than the historical cost method. It worked very well for financial companies. Enron was the first non-financial company to adopt the fair value system to record its assets and liabilities at their present values. Enron’s financial statements provided misleading and unreliable information. There was, of course, fraudulent intent but it became very easy for the management to commit fraud under the aegis of the fair value system. The window-dressed financial statements caused heavy losses to many investors and Enron was shut down and liquidated. The fair value system has been under scrutiny ever since. This is also a demerit of rule-based accounting as the fair value system was efficient for financial companies but its application on non-financial companies is debatable. Also, it is certain that achieving both relevance and reliability is not possible in many cases. Therefore, the overall objective of financial statements cannot be achieved using rule-based accounting. The ‘principle-based’ standards are thought to be more useful than ‘rules-based’ accounting standards because of their flexibility. The preparers of financial statements can use their own judgment to tackle circumstances in which the rules are not helpful. Section 108(d) of the Sarbanes-Oxley Act of 2002 had significantly influenced the debate whether the principles are better than rules. According to the report that lead to the enactment of this section, the system of corporate governance and financial reporting needed improvement on a large-scale because the then used system had failed to detect fraud in major corporations. “…the Act called for improvement in the checks-and-balances that govern the production of financial information provided to investors and, thereby, served notice on bad actors that they would be discovered and dealt with for their misrepresentations” (2002). This section called for objectives-oriented standard setting. The major objective of financial reporting was to present fairly the financial state and affairs of an entity. It also emphasized on the fact that the management should be ready to take responsibility of all the provided financial information. The management was also directed to be responsible to provide crystal-clear disclosures to the investors. According to the report, when the auditors are applying a particular standard in practice, they must be able to take their decisions in a manner that fulfills the accounting objective of that standard. Each standard must be drafted according to the objectives set by an overarching principle so that the accounting practice is as much harmonized that is possible. There should be no exceptions because these create deviation from the attainment of objectives. An exception is tantamount to exemptions in most cases and the objective of comparability stays unfulfilled. The objectives-oriented standard must clearly state the class of transactions to which it applies and must provide the preparers and auditors with a structure using which they can determine the appropriate accounting for those transactions. The FASB responded to this proposal shortly as it intended to continue to be the main body for regulating financial reporting in US. It upheld the suggestions of the aforementioned report but also explained that the need to maintain standards was already in the objectives of FASB. It acknowledged the fact there was room for making such changes that would increase the role of judgment in the preparation of financial statements (FASB, 2004, p4). FASB also acknowledged that there was a need to provide guidance as to how the standards should be applied. IASB also made some changes by revising its standards and settled down to see the effects of those changes. This period was called a “period of calm” by David Cairns (2011). He also mentioned that there is a need to make simpler, shorter and fewer standards because the current standards are very complex which creates confusion and exceptional minds can easily find loopholes to commit frauds while guising them as innocent mistakes (Donelson et al, 2009). IASB incorporated some rules that encouraged the exercise of professional judgment. To increase flexibility, IASB also introduced two types of treatments for some cases. One treatment is called “benchmark treatment” which is the recommended treatment. The other treatment is called “Allowed Alternative Treatment”. It was an effort to make the standards flexible. For instance, the benchmark treatment for borrowing costs is that they must not be added into the cost of assets and must be classified as expenses. The allowed alternative treatment allows the entities to incorporate the borrowing costs in the costs of their assets i.e. capitalize their borrowing costs (IAS 23). The Institute of Chartered Accountants of Scotland (ICAS) conducted a research and prepared a report in which it recommended that the ‘principles’ were better than ‘rules’. This report defined principle as “…a general statement, with widespread support, which is intended to support truth and fairness and acts as a guide to action” (2006, p3). Rule-based accounting system purports to provide comparable financial information. It is because of the ubiquitous bright-line tests that are applied by all the preparers in similar types of transactions. This comparability is, in fact, illusory because there are transactions that have very little difference end up receiving different treatments when the same test is applied for both (SEC, 2002). Therefore, rule-based standards cannot guarantee comparability. The rule-based standards have thrived on the belief that they create more comparability. To attain more comparability, more rules have been added over time. It should be noted that in their bid to create harmony in accounting practice, the rules tend to reduce and even eliminate the role of professional judgment. The rules are able to make an entity do away with the legal requirements in respect of a transaction or other event by providing a precise answer. However, rules may not be able to provide a fair representation of the entity’s financial state. A fair view might be obtained if the preparer is allowed to use his professional judgment to address the issue. Therefore, it is not certain that the rules would ensure the prevention of illegal practice. Rule-based standards work on the basis of reactionary measures. When a problem has occurred, the rules are modified or new rules are added so that the problem can be dealt with in the future. However, principle-based standards encourage professional judgment which allows the preparers to solve the problem as it arises hence avoiding the problem in the first place. There are many examples of rule-based standards in which the rules state that it is unnecessary to quote specific cases. The ICAS report found that such requirements are actually providing a road map to avoid the promulgation of crucial information. This is detrimental to the regime of true and fair view. Also, in order to be comprehensive and address every issue in detail, the rule-based standards become very complex and difficult to be understood (McPhail & Walters, 2009). As rules are required to be followed, the preparers of financial statements try to follow each and every rule word by word. In this process, they forget or inadvertently disregard the spirit or the true objective for which a standard was set. These standards get more complex when preparers and auditors ask for more guidance because it is believed that when financial statements are prepared while following the standards, the possibility of a lawsuit is minimized. The requirement to follow certain standards makes the accountants somewhat “robotic” because they tend to go by the book in all scenarios. The opportunity to exercise one’s own skill and judgment is curtailed significantly. It has been observed at some times that US GAAP is a principle-based approach. But when it is compared with the principle-based IFRS, it seems to be a rule-based approach because the need of more rules with time has made it abundant in rules. The main objectives of the IASB are: a) “To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the various capital markets of the world and other users of the information to make economic decisions; b) To promote the use and rigorous application of those standards; and c) To work actively with national standard-setters to bring about convergence on national accounting standards and IFRSs to high quality solutions.” (2011, p24) In order to achieve these objectives, IASB has brought in so many rules that their accounting standards have become very complex. This is because when IASB attempts to address each and every issue to ensure the achievement of its objectives, it is bound to add more information and hence, more rules. Sometimes, a problem arises in only one particular jurisdiction. The board adds new rules to address this issue and other jurisdictions also have to implement those rules regardless of the fact that they do not have such problems. Therefore, comparability is affected. IFRS is becoming more widespread with the passage of time. This might lead in a demand for more guidance which would result in more rules and hence more complexity. This would not be the case in principle-based standards because the need of clearer interpretation would be almost zero. The existing principles would suffice and the professional judgment would tackle novel issues. There is one conflict between the report of ICAS and that of SEC i.e. regarding the objectives-based standards being the same as principle-based standards (ICAS, 2006, p4). The ICAS report-makers believe that when an objective is defined according to “an appropriate level of specificity”, there is a risk that such standards would revert back to the rule-based approach. This is because the standards would attempt to make sure that they are properly complied with by all the entities. This would lead to addition of rules. Also, objectives-based standards tend to reduce the element of professional judgment which is contrary to one of the basic traits of principle-based standards. Principle-based standards must provide a general framework within which the preparers would be given sufficient room to exercise their own judgment. Therefore, the regulators need to be expectant of diverse judgment-based outcomes. The role of regulators is the key in accepting and supporting such outcomes. True and fair view must be the objective of the principle-based standards that must be kept in mind. Any rule that opposes the attainment of this objective must not be followed. There is a problem for the standard setters in producing ‘principles-based’ accounting standards. The biggest problem is of shifting to the new standards. When there is a change, the step of “unfreezing” is the hardest. Currently, the auditors and preparers are accustomed to do their accounting on the basis of rule-based standards. They would be required to especially train to adapt to the new system. The principle-based system would require them to take intelligent and brave decisions. Taking of such decisions would require a big heart because these accountants would think that going against the conventions might bring dire consequences. They would have to be trained to uphold the objective of true and fair view in all scenarios. In practice, it is a very difficult and a time-taking process. Principle-based accounting standards are required to provide the accountants with a basic structure. Provision of such structure might prove to be inadequate for accountants that might create confusion hence leading to “compliance” issues. Lack of compliance with the standards might lead to a failure in the achievement of the objective of true and fair view. Non-compliance of standards would lead to the provision of unreliable information and there would be little or no comparability. In theory, it is easy to mention that achieving perfect comparability is impossible in accounting. But in practice, there are many users of financial statements that depend very highly on comparability. If comparability is done away with, it would lead to a new debate which would go in favor of the rule-based accounting system. It has been mentioned above that for the success of principal-based standards, the regulators must encourage professional judgment and expect a range of interpretations from different preparers and auditors. When preparers know that the regulators would allow them a certain degree of deviation from the standard, this might result in an uncertainty. As the regulation would be prospective to guide future conduct in this case, the preparers would be uncertain as to whether they are interpreting the standard correctly. This is another problem which would result from lack of guidelines (Black et al, 2007) Another problem is the lack of consistency among the principles. Some of the principles might be so much mandatory that they would become rules. When presented in combination with “semi-mandatory” principles, there might be a need of lengthy and complex details of guidelines which would reintroduce the problem brought about by the rule-based standards. Even if the principles are not binding, some preparers of financial statements might still use these as if they were binding. This would attach to them a similar value to that of rules. As each new guideline would present a new idea, the overall meaning of the guidelines might be lost into oblivion. There is also a lack of predictability. As different type of treatments would be exercised for similar transactions or other events by different accountants, it would be extremely hard for users to predict how these transactions would be dealt with in the future. The principle-based standards can prosper only if there is a high level of trust among the standard setters, preparers, auditors, regulators and other users (ICAS, 2006). If there is a lack of trust among these, the principle-based standards cannot succeed. For instance, the regulators might not believe that the preparers would be able to interpret the objective of a standard correctly and would be able to take efficient steps to achieve that objective. Achieving convergence among various accounting bodies has been one of the chief concerns of standard setters. This has been IASB’s desire for more than a decade and it has been trying to achieve convergence between IFRS and GAAP. It has succeeded in many cases but has failed in many others. One of less successful scenarios was “the (unnecessary) import of the detailed rules for assets held for sale…for those used to a principle based environment” (Cairns, 2011). It is, however, interesting to note that beyond convergence between IFRS and US GAAP, there is the prospect of adoption of IFRS in the US (Ernst et al, 2012). Convergence is an essential for a successful implementation of principle-based standards. There needs to be harmony among various concepts so that they all contribute to the achievement of true and fair view. There has been an argument that principal-based standards are not effective for small businesses because they are not able to comply with the complexities that are to be engaged with to comply with a standard. They simply like to be told what to do so that they can just file their tax returns. Overall, there are some critical factors that are required to be existent for the success of principal-based standards which is a long-term process. It is not possible to introduce such radical changes in the accounting system right now but the concerned authorities are aware of the fact that the rule-based accounting is not the answer to the accounting problems. Preparation of principal-based standards needs sufficient amount of work for simplicity and needs a clearer hierarchy of overarching concepts. This can be done if a regulatory body concentrates more on significant issues than on detailed matters. Also, the lack of convergence can only be solved by building up a trust among regulators, preparers and auditors. References Black. J, Hopper. M, Band. C, 2007, ‘Making a success of Principles-based regulation’ FSA Special Feature. London: FSA. Cairns. D 2011, ‘Professional Briefing’, International Reporting, Vol. 148, Issue 1417, p.71. Donelson. DC, 2009, Rules-Based Accounting Standards and Litigation, McCombs School of Business, University of Texas, Austin. Ernst & Young, Wiley. J, 2012, International GAAP 2012, John Wiley & Sons Ltd, United Kingdom. FASB (2004), ‘FASB Response to SEC Study on the adoption of a Principles-based Accounting System.’ Connecticut: FASB. Accessible at: http://www.fasb.org/response_sec_study_july2004.pdf [Accessed 2 May, 2012] IASB, 2011, IAS 2: Inventories. London: IASB. IASB, 2011, IAS 23: Borrowing Costs. London: IASB. IASB, 2011, Framework for the Preparation and Presentation of Financial Statements. London: IASB. IASB, 2011. Preface to International Financial Reporting Standards. London: IASB. ICAS, 2006. ‘Principles not Rules: A Question of Judgment.’ ICAS, Edinburgh. Accessible at: http://icas.org.uk/principlesnotrules/ [Accessed 2 May, 2012] ICAS, 2007. ‘Principles into Practice Key points from the “Too Late for Principles” conference held in October 2006.’ Edinburgh: ICAS. Accessible at: www.icas.org.uk/site/cms/download/PrinciplesIntoPractice.pdf [Accessed 2 May, 2012] Mcphail. K, Walters. D, 2009, Accounting and Business Ethics, Routledge, New York. SEC, 2003. ‘Study Report Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002.’ U.S. SEC. Accessible at: http://www.sec.gov/news/studies/principlesbasedstand.htm [Accessed 18 January, 2012] Read More