Accounting Standards: Rules versus Principles - Term Paper Example

Accounting Standards: Rules VS Principles Introduction In recent times accounting and financial scandals have brought to fore the issue of accountingstandards. Currently rule-based accounting standards are longer and more complex filled with specific details in an attempt to address as many potential contingencies as possible. Also the role of professional judgment became unimportant and rules took over the professionalism. So, the debate started whether the current financial reporting system in the U.S. is undesirable or inappropriate because it is rule based. In order to address the issues with rule based standards the Sarbanes-Oxley Act of 2002 made recommendations to examine the feasibility of a principles-based accounting system. Many top accounting firms have also supported the switch from rule-based accounting system to principles-based accounting system. Even the Financial Accounting Standards Committee (FASC) of the American Accounting Association is more in favor of a principles-based accounting system. Sarbanes-Oxley Act 2002 Hence, the promulgation of the Sarbanes-Oxley Act of 2002 has possible implications for the adoption of principles based financial reporting standards. This particular Act has come into force in order to provide detailed and prescriptive corporate governance guidance, at the federal level, in particular. Also this Act has special emphasis on matters related to financial reporting and auditing. Previously, the principle based outlook has been associated with the state level, where the fiduciary duties of care and loyalty have formed the basis of governance guidance for officers and directors of corporations. Consequently, the Sarbanes-Oxley Act is completely different from the previous statutes, in the sense that it is now more principle based and is imposed at the federal level rather than the state level. This is an important angle to the whole issue of standards. Now the officers and directors or preparers of financial reports and the audit committees will seek ever more detailed guidance as to precisely what is expected in terms of their role in financial reporting. So, a clash of requirement by demand for rules and principle based standards is foreseen by the analysts. Differences If explained in the simple language then principles based accounting standards provide more of a conceptual framework while rule based are more detailed instructions. Hence, principles-based accounting system is based on general objectives rather than detailed guidelines. A principles-based accounting system would explain the objectives using some examples rather than detailed procedures. “The research literature suggests several broad conclusions about the incremental effects of additional rules on a standards ability to communicate clearly and constrain aggressive reporting. First, a key to accurate communication is striking the right balance between providing enough rules to communicate clearly and not so many rules that practitioners are overwhelmed. Increasing the extent to which the various rules in a standard are related to each other should help avoid overwhelming practitioners with complexity” (Nelson, 2003) . Perhaps the chief advantage of principles-based accounting rests in its expansive guidelines that can be applied to numerous situations. Broad principles stay away from the drawbacks linked with specific requirements that permit contracts to be written specifically to manipulate their intent. Providing broad guidelines may improve the representational faithfulness of financial statements. In addition, principles-based accounting standards allow accountants to apply professional judgment in assessing the substance of a transaction. This approach is substantially different from the conventional approach common in rules-based accounting standards. Another advantage of a principles-based system is that it would result in simpler standards comprising less pages as compared to pages and pages of rule based standards. On the other hand principles based standards would also result in lack of precise guidelines that could generate inconsistencies in the application of standards across organizations. 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, it would be difficult for companies to determine if liabilities are probable or only reasonably possible. Examples Here we would analyze two examples for the relative analysis of rule and principle based standards. Lease Accounting: The most common discussed example is that of leasing and so we would also discuss the well-known case of the capitalization of leases. According to the requirements of the IFRS a lease should be capitalized as an asset and a liability when it ‘transfers substantially all the risks and rewards’ to the lessee. There are no numerical or other technical rules related to the unclear principle mentioned above. In fact, this vague principle takes its inspiration from another principle of substance over form. According to standards and rules set by the accounting bodies that capitalization can take place where the length of the lease equals or exceeds 75 percent of the useful life of the asset or where the present value of the lease payments equals or exceeds 90 percent of the fair value of the asset. The clarity and verifiability stands can be seen in the above mentioned rule. This clearly shows how a rule based on a principle substance over form been used in the standards. Many experts here have the view that even though rule has been made using the principle but they have made this rule using the wrong principle. According to many experts the more appropriate principles are the definitions of assets and liabilities in case of leases. Considering that lessee has power over resources for a period, and therefore has an asset. If the appropriate principle is adopted then, the point about ‘substantially all the risks and rewards’ with the arbitrary 75 percent and 90 percent becomes needless. In the case of this interesting topic of leases, making a standard on the appropriate principle that is the definitions of assets and liabilities would not simply be disadvantageous just because of use of principle instead of rule. Thus the use of principle would not result in any indistinctness, lack of verifiability, or lack of comparability. In fact, all no cancelable leases would be treated in the same way. “An alternative view of applying the asset/liability definitions to leasing is that a lease is an executory contract, i.e., a contract that is equally unperformed by the lessee and the lessor for the remaining period of the lease. To be consistent with other executory contracts (e.g., see IAS No. 37, para. 3), leases would not be recognized as assets or liabilities. Disclosure of the lease commitments would then be the suitable alternative. Whichever of the two views is taken, capitalizing leases on the basis of whether they exceed a 75 percent/90 percent threshold makes no sense” (Nobes, 2005). Employee Benefits: Another example that wee can consider here in this analysis is that of employee Benefits. The standards related to post-employment benefits are consistent with the definition of a liability which is not the case with leasing standards. Even though the definition is compliant but there are other problems with measurement rules. In this case in particular the definition of liability does not solve all issues; hence, measurement rules are essential in the standards on this topic. For example, it is vague whether to confine the size of the liability to the benefits before now vested. So we can say again with regard to this example that there are rules that are complex and not based on principles. Another View Another view is that some experts suggest that some topics require a mixed approach rather than a single approach. Financial reporting standards are in general based on principles, derived from the FASBs Conceptual Framework, but they also contain elements such as scope and treatment exceptions and detailed implementation guidance that make them also appear to be rule based. So, some topics require that rules should be mentioned with some concepts but the extent of rules is limited. In such cases rules could be used under the umbrella of principles. If we look at the past trends then we also come to know that many experts wrote essays in the 1960s and the 1970s that attempted to criticize rulemaking in support of the promulgation of principles. Unfortunately, nobody ever succeeded completely. Not achieving this differentiation emerges because accounting is a human invention that exists for utilitarian reasons. Some suggest that there is no clear dividing point between what is a rule and what a principle is, and different individuals will evaluate a statement as a rule or as a principle differently. Some people consider formulating an ideal standard an impossible feat. They believe that a perfectly consistent conceptual framework might be constructed in some utopia, but on earth this goal will always remain an ideal. As such, its unfair to criticize the current process by the Financial Accounting Standards Board for formulating new statements. Most accounting bodies and organizations require that information provided in standards should be relevant, reliable, and comparable across reporting periods and entities Comparability/consistency in financial reporting is considered a good thing. It is generally considered that rules can help with clarity/comparability. But sometimes it happens that rules in existing standards come about because a standard is based on a poor principle or because it lacks principle. Hence experts argue that use of a more suitable principle could diminish the need for arbitrary and detailed rules. That is, the taking away of rules can sometimes be connected with increased clarity and comparability. It is also believed that the lack of bright-light standards may reduce comparability and consistency, a primary precept of financial accounting. However, many accountants seem to prefer rules-based standards, possibly because of their concerns about the potential of litigation over their exercise of judgment in the absence of bright-line rules. For the implementation of principles based standards accounting bodies and experts must look into the important elements of comparability, relevance, and reliability with special attention to the effects of detailed implementation guidance. Issues and Concerns There are some important issues and concerns that need to be addressed if the principles based standards are to be enforced. Transition: The important question that needs to be addressed is that of transition from a lengthy rules based transition to a principles based standards. When standards change accounting policies also change leading to over-time inconsistencies in reporting (‘the historical financial reports of a firm are not comparable with its current financial reports whenever accounting policies change’). Due to the inconsistencies the important elements like relevance, reliability and/or comparability get affected and so in return the quality of financial reporting will be temporarily diminished, by some unknown amount, during the transition period. All accounting bodies are now working to look into this matter of transition. U.S. GAAP also offers a mixture of transition alternatives when accounting standards modify. One suggestion in this regard is Retroactive application. In Retroactive application the financial reports are restated for all periods presented. This enhances consistency and comparability and imposes the greatest costs on preparers and auditors. Another solution is prospective application. This application on the other hand simply applies the new standard either on a given date or as of a fiscal year or quarter. This reduces consistency and comparability and imposes the least costs on preparers and auditors. ‘Cumulative effects’ approach is another approach suggested by U.S. GAAP. According to this approach the difference between retained earnings at the beginning of the period and the retained earnings that would have been reported if the new accounting standard was applied retroactively to all affected prior periods. This approach also reduces comparability and consistency. Exceptions: Rules generally have terms like scope restrictions, exceptions, subsequent precedents, implementation guidance, etc. Exceptions are also considered important elements of rule based accounting standards. With the implementation of principles based standards there is an indication that no or very few scope and treatment exceptions would remain in standards. Thus the absence of exceptions would result in increased volatility in reported income numbers. There would also be discontentment with a principle based reporting system that does away with treatment alternatives which are present simply to smooth income with preparers, investors etc. “Accounting research (for example, Barth et al. 1999) has also documented apparent rewards, in the form of higher price-earnings multiples, to firms with persistent patterns of increasing earnings. Research, therefore, has shown that income volatility matters, so it is an empirical issue how contracting incentives and investor responses to earnings would shift if the consistent application of principles-based standards were to increase reported earnings volatility” (Schipper, 2003). These economic volatilities and the exception are also the important matters need to be looked into. Professional Skill & Proficiency: A main concern shown with respect to a shift to a more principle based standards would be increased requirement of professional Skill & Proficiency. For example, for matters like measurement, the type and amount of expertise and skills required of both preparers and auditors will shift. At present, the standards available in U.S. provide details and descriptions about the applicability of standards. In most of the cases standards are explained using numerical examples that demonstrate how to apply the standard to particular facts and conditions. If details of the rules are abolished then an extra onus will lie on the shoulders of individual firms and their auditors to work out the application details by looking to the standards objective. With the implementation of principles the number of required estimates and judgments would increase. In order to meet the standards of relevance the financial reports prepared in accordance with U.S. GAAP more and more are built on estimated or measured amounts and not transaction amounts. Again, in order to estimate amounts a measurement objective, such as fair value, and a measurement approach, such as application of a model or application of a discounted cash flow technique is required. So, an appropriate level of common understanding about when and how to apply these measurement approaches will also be a responsibility on part of preparers and auditors. Hence there is a possibility that reliance on measurement expertise would increase. This in turn would require for accounting education system to develop the needed measurement skills within the accounting education program. While currently, accounting education program offers training in valuation of whole enterprises, or subunits of enterprises, based on discounted cash flow or discounted residual income approaches, the advanced measurement techniques and skills to measure the amounts to be reported for specific assets and liabilities are still not imparted to the learners. So, this aspect should also be looked into when switch is made. References: Nelson, M. (2003). Behavioral Evidence on the Effects of Principles- and Rules-Based Standards. Accounting Horizons. Vol: 17. Issue: 1. Nobes, C. (2005). Rules-Based Standards and the Lack of Principles in Accounting. Accounting Horizons. Vol: 19. Issue: 1. Schipper, K. (2003). Principles-Based Accounting Standards. Accounting Horizons. Vol: 17. Issue: 1. Read More