Running head: PRINCIPLES-BASED VERSUS RULES-BASED ACCOUNTING
Principles-Based Versus Rules-Based Accounting
Karla Law
Liberty University
Accounting 301-B07
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Principles-Based Versus Rules-Based Accounting
Abstract
Principles-based and rules-based accounting systems each have their advantages and
disadvantages. When carefully examining these two accounting systems, it is clear to see that
neither is better than the other. However, many individuals have the misconception that
principle-based accounting is better. This is due to the fact that in recent years, the Financial
Accounting Standards Board (FASB) has issued several standards that are considered more
principles-based than rule-based. Nonetheless, that does not mean that principles-based
accounting is better. Therefore, this paper will examine the pros, cons, ethics and virtues of both
rules-based accounting and principles-based accounting.
Keywords: GAAP; FASB; SEC; Principles-Based Accounting; Rules-Based Accounting
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Principles-Based Versus Rules-Based Accounting
Introduction
Accounting can be a very confusing and intimidating subject for many individuals.
Reason being, is that accounting has its’ own language per say. It is imminent that one learns the
key terms to this challenging subject in order to obtain a better understanding of the matter. For
starters it is key that one learns the differences and similarities of principles-based accounting
and rules-based accounting. Once gaining that knowledge it is important to know what the
generally accepted accounting principles (GAAP) are and what effect they have on principle-
based and rules-based accounting. As well as, the effect they have on the Securities and
Exchange Commission (SEC), Financial Accounting Standards Board (FASB), and ethics. This
will allow one to better understand the dos and don’ts on financial statements.
GAAP
What is generally accepted accounting principles? According to Spiceland, Sepe,
Nelson and Thomas, “generally accepted accounting principles (GAAP) is a dynamic set of both
broad and specific guidelines that companies should follow when measuring and reporting the
information in their financial statements and related notes (2016).” The GAAP covers things
such as revenue recognition, balance sheet item classification and outstanding share
measurement. It is important for one to understand the concept of the GAAP in order to
understand the accounting information at hand. “GAAP aims to make information relevant,
reliable, and comparable. Relevant information affects the decisions of users. Buyers trust
reliable information. Comparable information is helpful in contrasting organizations (Wild,
Shaw, & Chiappetta, 2013).” However, because the GAAP is only a standard, some accounting
professionals may choose to “play” with the numbers. Therefore, one must carefully examine a
company’s financial statements.
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Principles-Based Versus Rules-Based Accounting
FASB
The Financial Accounting Standards Board (FASB) was designed in 1973. “FASB is a
designated organization in the private sector for establishing standards of financial accounting
that govern the preparation of financial reports by nongovernmental entities (Wild, Shaw,
Chiappetta, 2013).” “Those standards are officially recognized as authoritative by the Securities
and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and
reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public
Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979)
(FASB, 2002).” It is important to have said standards in order to have an efficient functioning
economy. Reason being, is that allocations of resources rely on truthful and understandable
financial reporting information (FASB, 2002).
SEC
“The Securities and Exchange Commission (SEC) is a government commission created
by Congress to regulate the securities markets and protect investors (SEC, 2003).” The
Securities and Exchange Commission is made up of five commissioners. They are selected by
the United States President, and then are approved by the United States Senate. The SEC has the
responsibility of protecting the investing community from fraudulent and manipulative practices
within the securities market (SEC, 2003).
Interpretations of Principles-Based Accounting
What is principles-based accounting? Principles-based accounting is also known as
objectives- oriented (Spiceland, Sepe, Nelson, & Thomas, 2016). Due to the fact that principles-
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Principles-Based Versus Rules-Based Accounting
based accounting does not contain a strict set of rules, many can argue that it is up to
interpretation. Some of those interpretations are as follow:
“Principles-based accounting are objectives-oriented standard (Benston, Bromwich, &
Wagenhofer, 2006).”
“Principles-only standard may present enforcement difficulties because they provide
little guidance or structure for exercising professional judgement by preparers and
auditors (SEC, 2003).”
“Principles-based standards require the accounting professional to exercise judgement
(Denton, 2012).”
“Principles-based accounting provides a conceptual basis for accountants to follow
instead of a list of detailed rules (Shortridge & Myring, 2004).”
“The inherent characteristics of a principles based framework is the potential of different
interpretations for similar transaction (Forgeas, 2008).”
“Financial statement prepares are less likely to report aggressively when applying a less
precise (more principles based) criterion than when applying a more precise (more rules
based) criterion (Agoglia, Doupnik, & Tsakumis, 2011).”
“Adopting a principles-based approach will result in greater judgement (FASB, 2002)”
Due to the fact that there is no specific set of rules, critics believe that there is too much
wiggle room for companies. This is because the principles that pertain to the principles-based
accounting system can sometimes be stretched.
Rules-Based Accounting Characteristics
Rules-based accounting differs from principles-based accounting in the sense that it has a
specific set of rules that must be followed if complying with the rues-based accounting
standards. Therefore, it gives guidance. According to SEC, “rules-based accounting standard are
filled with the specific details in an attempt to address as many potential contingencies as
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Principles-Based Versus Rules-Based Accounting
possible (2003).” Therefore, rules-based accounting tends to be more detailed. “Rules-based
standards typically provide very detailed guidance with bright-line test (Agoglia, Doupnik, &
Tsakumis, 2011).” Unlike principles-based accounting, rule-based accounting can be considered
aggressive. The reason being is that the accounting professionals are required to abide by the
specific set of rules. However, this ‘aggression’ “creates a roadmap to avoidance of the
accounting objectives inherent in the standards (Benston, Bromwich, & Wagenhofer, 2006).”
Advantages
Principles-Based Accounting
Principles-based accounting system is practical
Principles-based accounting is more flexible
Principles-based accounting system are considered by some to be the answer to
the problems created by rules-based accounting
Principles-based accounting system creates a much less aggressive reporting
system
Principles-based accounting system can create a more meaningful and detailed
financial statements
Rules-Based Accounting
Rules-based accounting system provides guidance
Rules-based accounting system make financial statements more consistent and
comparable
Rules-based accounting is favored by companies because it gives them detailed
instruction and helps eliminate any ambiguity about the structure of the
transaction
Rules-based accounting is favored by auditors because it is clear-cut and aids in
avoiding disputes with clients
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Principles-Based Versus Rules-Based Accounting
Rules-based accounting is supported by many accountants because without rules
their judgement could possibly questioned and be brought to court
Rules-based accounting is supported by securities regulators because it is easier to
enforce, thanks to the detailed direction it provides
Disadvantages
Principles-Based Accounting
Principles-based accounting contains a limited amount of rules
Principles-based accounting lacks direction
Principles-based accounting can be unreliable and inconsistent due to its lack of guidance
Principles-based accounting’s inconsistency and unreliability makes the financial
statement incomparable to other business
Principles-based accounting could lead to the manipulation of financial statements
Principles-based accounting is conflicting because it requires significant direction for
management judgement
Principles-based accounting can make compliance more difficult
Principles-based accounting is complex
Principles-based accounting is expensive
Principles-based accounting is time-consuming
Rules-Based Accounting
Rules-based accounting can create unintended complications in preparing financial
statements due to its complexity
Rules-base accounting is more aggressive
Rules-based accounting can become irrelevant as the economic environment evolves
Rules-based accounting can create unwarranted pressure that can result in unfaithful
representation of the financial statements
Rules-based accounting scandals have the potential to outweigh the benefit cost
Ethics and Professionalism
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Principles-Based Versus Rules-Based Accounting
Ethics and professionalism are key elements that pertain to both rules-based accounting
system and principles-based accounting system. According to Spiceland, Sepe, Nelson, and
Thomas “ethics is a term that refers to a code or moral system that provides criteria for
evaluating right and wrong (2016).” “Ethics is a key characteristic that distinguishes a profession
from other occupations is the acceptance by its members of a responsibility for the interest of
those it serves (Spiceland, Sepe, Nelson, & Thomas, 2016).” Therefore, being an accountant
professional automatically means that one supports its code of ethics. This code of ethics
provides a set of rules and guidelines for professional performance within a given field. These
rules and guidelines can aid in avoiding ethical dilemmas. The following steps can aid
individuals when determining right from wrong:
Steps
1. “Determine the facts of the situation. This involves determining the who, what, when,
where, and how.”
2. “Identify the ethical issue and the stakeholders. Stakeholders may include shareholders,
creditors, management, employees, and the community.”
3. “Identify the values related to the situation. For example, in some situations
confidentiality may be an important value that might conflict with the right to know.”
4. “Specify the alternative course of action.”
5. “Evaluate the courses of actions specified in step four in terms of their consistency with
the values identified in step 3. This step may or may not lead to a suggested course of
action”
6. “Identify the consequences of each possible course of action. If step 5 does not provide a
course of action, Asses the consequences of each possible course of action for all of the
stakeholders involved.”
7. “Finally, make you decision and take any indicated action”
(Spiceland, Sepe, Nelson & Thomas, 2016)
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Principles-Based Versus Rules-Based Accounting
Virtues
This leads to the five cardinal virtues that every accounting professional should possess.
These virtues are some what reflected within the code of ethics. They consist of integrity,
objectivity, diligence, loyalty, and professional behavior.
The concept of integrity consists of two key elements, honesty and courage (Spalding &
Oddo, 2012).” Due to the fact that an accounting professional is responsible for reporting truthful
information it is in his or her best interest to be 100% honest. However, one must be courageous
when telling the truth. The reason for that is that sometimes the truth can be hard to confront.
Having integrity will aid when being tempted to exaggerate the truth in order to please a client.
Being objective can be characterized by acknowledging the external standard for
measuring ones performance. Within the accounting field there is the “fair representation”
standard for financial reporting of a particular business. Quality, reliability, and usefulness are
used to measure the fair representation of financial reports. Following these standards is not only
about technicality; it is also about being ethical (Spalding & Oddo, 2012).
“In accounting, diligence is expressed mostly by the virtue of truth seeking. Accountants
cannot be effective truth tellers unless they are truth seekers.” This requires an intention as well
as the skills to implement the intention. Mere curiosity will not suffice, nor will mere data
gathering without an alert and informed focus on the purpose of the data gathering (Spalding &
Oddo, 2012).” Therefore, accounting professionals must be alert to all signals of manipulation or
issues with the accounting information provided.
One of the hardest virtues to balance is loyalty. An accounting professional must be loyal
to his employer, yet, stay loyal to his or her own convictions. However, an accounting
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Principles-Based Versus Rules-Based Accounting
professional must learn to be discreet in order to keep an employer’s information confidential.
This will create an excellent work- related relationship between the client and the accountant.
Trustworthiness is a key foundation for any ethical system (Schwartz 2002). In the
accounting profession and it can be argued that the overriding meta-virtue for accountants is
trustworthiness. Each of the four preceding virtues supports the trustworthiness of the
accountant, and generally pertains to the accountant’s work as such. Accountants who maintain
integrity, objectivity, diligence, and a proper notion of loyalty can be, and are more readily
trusted than accountants who do not develop, maintain and optimize these virtues.
Conclusion
The purpose of financial accounting is to provide investors with financial information for
a particular business. This information aids in their decision making process on whether or not to
invest in said company. There are several stakeholders with different roles that are involved
when making such decisions. First, businesses communicate their financial standing position to
investors by providing them with their financial records. Auditors then examine the financial
information provided to determine the reliability of the business. Financial analysts study the
information provided by the companies and make the investment recommendations to their
client. The ideal role of the SEC is to protect investors, maintain fair, orderly, and efficient
markets, and facilitate capital information by exercising its authority to bring civil enforcement
actions against individuals or companies alleged to have committed accounting fraud or provide
false information. With the expectation that the accounting information is provided by the
companies is reliable, investors make investment decisions based on their own judgement or the
recommendation made by financial analyst. If the individuals involved in the decision-making
process fail to do their job, it can result in the misallocation of capital. The goal of the FASB is to
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Principles-Based Versus Rules-Based Accounting
protect investors from market securities. They issue standards so that the investors receive
reliable statements from the company. Therefore, there is no telling which financial system is
better. Whether it is principles-based accounting system or rules-based accounting system. They
both have their advantages and disadvantages, so really it is a matter of perception.
References
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