Principle-Based and Rule-Based Accounting Standards - Case Study Example

Principle Based and Rule Based Accounting Standards Student’s Name: Institution’s Affiliation Course Code Date of Submission: Abstract There have been claims that rule based standards are more effective than principle based standards. It is evidenced that rule based standards prevents the accountants from litigation while principle based standards eliminates complexity of standards. In this essay we are committed to discuss the reasons why standard setters are more likely to use rules and principles when developing standards. The essay also identifies and explains some cases in the two companies namely Enron and WorldCom where they use rules based standards and principles based standards. The analysis is very important as it is able to produce a valid conclusion on which standard is appropriate over the other. In this case we concluded that the two standards work appropriately together since rules are made out of principles. Introduction The accounting standard setting bodies use mix of rules and principles based standards when making accounting standards. This action of accounting bodies to use rules and principle is of great importance as it is able to increase standardisation and comparability of accounting information of different firms and countries (Schipper, 2003). This essay is vividly meant to provide a deep explanation and discussion on why accounting standards are based on rules and principles and also identify one rules-based standard and principles-based standard that the companies have adopted. This will ensure that there is an understating of different accounting standards that different companies can employ when preparing financial statement. Part I Accounting standard setting bodies use rules and principle based standards for a number of reasons. These reasons are clearly explained below. Truthful presentation of economic reality For the investors to have high satisfaction, it is important for the organization to use accounting system that can produce accounting information that reflects true and correct economic performance. The rules and principles ensure that the investors are able to understand the economic reality of the business and any activity (Benston, 1976). These accounting standards that are based on rules and principles must be able to show economic substance, generate fair presentation and must be of high integrity. Responsive to the needs of users for clarity and transparency The rules and principle based standards ensure that there is a transparent disclosure and presentation of financial information to users. This increase their understanding and confidence in the information contained in the financial report made following accounting principles (Benston, 1976). In the preparation of the financial report, the stakeholders such as investors must be kept in mind but not be used as an afterthought. Since financial statements are currently complex and hard to understand by the investors, both the rule and principle based standards must be formulated with a well informed objective to increase the understanding the information contained therein (Schipper, 2003). The use of these kinds of accounting standards must ensure that they elicit information that encourages business stakeholders. Consistency with a clear Conceptual Framework The use of rules and principles to make accounting standards ensure that there is consistency with the conceptual framework. The conceptual framework used must be able to increase the understanding of auditors and investors with the approach that underpin different accounting standards. The rules and principles used in the development of accounting standards will ensure that there is no conflict that arises between the standard and the conceptual framework (Benston, 1976). The bodies in charge of the development of standards must be asked to determine the standardization of the accounting standard developed. They also ensure that the principle and rules used is appropriate to ensure there is consistency. Based on an appropriately defined scope that addresses a broad area of accounting The use of accounting standards based on rules and principles ensure that there is a broad scope and formation f unnecessary complexity in every accounting element (Zeff, 1997). Hence, the process of preparing financial report is influenced to be in a tree format but not in a forest format when providing investors with economic picture. Rule and principle based standards solve the above problems by enabling broad scopes and also has a fair conceptual framework, limited standards that provides more information in the financial statement and other financial transactions. Written in clear, concise and plain language Accounting standard bodies use principles and rules so that the financial reports should be prepared with a clear, concise and plain language (Zeff, 1997). This is meant to fulfill the rights of stakeholders such as investors to get financial report with clear and concise information. Rules and principles will ensure that accounting standards ensure that financial statements are prepared in the same manner. Rules will ensure that there is clear guidance on how accounting records are made and consistent procedures are followed to remove inconsistency. Allows for the use of reasonable judgment The use of rules and principles in the development of accounting principles provide an opportunity for the management to have a reasonable judgment that ensures auditors and accountants have clarity. It also allows the management to provide professional judgment which enables the users of financial statements to obtain useful financial information (Hope and Gray, 1982). The description of professional judgment is relative but in this case it can be said to be reasonable when, it is made at the right time depending on the facts used. The reasonability of the judgment is available when it can achieve the overriding objectives set by the standard setter. The standard setters and regulatory bodies must ensure there is an understanding that is capable of creating diversity which is influenced by reasonable judgment (Nobes, 2002). To achieve comparability is achieved by the enforcement of rules and principles used to develop standards but not limiting the use of judgment as suggested by other people. Part II There is a great debate by different firms on the best accounting standard to use when preparing their financial statements. The companies used to evaluate the benefit of each include Enron and WorldCom based on how they apply the accounting standards. It is suggested by Schipper (2003) that accounting standards that are based on rules depend on principles as he considers that the standard setters use principles when setting rules. This suggestion was supported by Nelson (2003) who seconds the argument that no standard should be said to be less rule based. In his argument he suggested that rules have the potential to enhance accuracy which guides the communication of standard setters. It is therefore important for all standards to have rules is because standards are more inconsistent with the conceptual framework for accounting bodies. It is also evident that the use of principles sometimes may cause clarity in communication. Rules-based standard is where management use detailed set of rules when preparing accounting records. The use of this standard is preferred by many accountants since without rules they can be prosecuted easily if their decision is incorrect (Zeff, 1997). The availability of strict rules when preparing financial statements to be followed by accountants, there are minimal mistakes which can lead to legal suits. It also ensures there is high accuracy and correctness which lead to high accountability. The only problem with the use of rule based standards is that it is likely to increase complexity during the preparation of accounting records. Subsidiaries This is accounted for by the use of rule based accounting standards. It is a situation where the parent company has more than 50% of shares in another company (Milburn and Chant, 1999). The rule requires that one company controls another company by exercising more voting rights than the other. In this case it is unnecessary to exercise control as stated by the accounting principle since the subsidiary company is not probably to go against the wishes of the other company (Mulford and Comiskey, 1988). The use of this principle is derived from the definition of asset which according to accounting principle must be controlled so as to be included in the consolidated financial statement showing financial position of the business. To balance the consolidated balance sheets the grouped company is expected to indicate that 3% of the assets are financed by external investors and can be removed from the balance sheet. This produces additional rule after the use of another rule when preparing consolidated balance sheet (FASC, 2003). The accounting principles therefore provide that the number of shares is only used when determining the voting power of the parent company over the subsidiary. This therefore produce a clear trade off that the bodies that set accounting standards face (Zeff, 1995). This therefore shows that the US accounting system selected more complex rules while IFRS took a blurred accounting principle. Principles-based standard This is where the company prepares its financial statements by using GAAP which is applied as a conceptual basis (Nelson, 2003). This standard uses simple set objectives which enables the accountants to prepare good financial reports. The advantage of this standard is that it is able to provide practical guidance. Example Lease accounting One of the best applications of principle based standard is in the reporting of leases. This principle requires leases must be capitalized in the same way assets and liabilities are done when there is transfer of risks and rewards (Watts and Zimmerman, 1978). The use of IFRS does not require the use of numerical and other rules which are available in unclear principles that depends on substance over a form. To make these principles appropriate, accounting standards needs capitalization when all the procedural tests are fulfilled including the where there is equal lengths of the lease or when it is more than 75% of the useful life. This rule is important in the provision of clarity and verifiability (Zeff, 1997). This is meant to illustrate FASB which uses rule that relies on principles of substance over a form. In this accounting topic, the description of asset and liabilities has no potential to provide any limitation of the principle as compared to rules. The principle based standard is not able to provide imprecision, variability and comparability (Alexander, 1999). None cancelled leases are accounted for in the same manner which ensure there is no transactional structuring to eliminate threshold. It also leads to accurate communication between the standard setters (Nobes, 1992). Another way of treating leases as asset and liability is when it is taken as executor contract which is not performed by the lessee and the lessor for the remaining period. To maintain consistency with the executor contracts, the lease should not be considered as an asset and liability. Conclusion My decision is based on the argument of Schipper (2003) who assumes that comparability of accounting records is a very important thing to consider. I concur with the assumption of Schipper since that rule can improve clarity and comparability. The information in this essay suggest that there are some rules found in existing standards due to the fact that the standard is made from poor or absence of principles. The application of a good principle eliminates the importance of arbitrary rules. The elimination of some rules is to improve clarity and comparability which is connected with the standards. In the same essay, there is evidence that the application of some principle is important in the diminution of optional bookkeeping techniques. This does not mean that I imply that principle based standard is more effective that rule based standard but some standards has a more extensive rules due to lack of principles or the use of poor principles which are not consistent to the framework. For that mater, the standards will be more effective or clearer or have greater comparability when rules are being reduced. I only examined two examples from IASB standards since listed corporations mostly use AISB standards. The conclusion based on the results of the analysis show that the complexity of rules can be eliminated by introducing appropriate principles is all the two cases. 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Nobes, The Development of Accounting in an International Context, Routledge. Read More