At the heart of a recent debate is whether a principles-based accounting system should replace the more concrete, yet inflexible, rules-based approach. For years, the accounting profession has been criticized for its “black and white” approach to setting rules. In some instances, quantitative thresholds and rules have replaced logic. The result is that in recent instances, companies have “technically” satisfied GAAP’s rules even though the substance of the transaction was contrary to the rules-based form. Below are arguments for and against a principles-based accounting system.
Congress passed the Sarbanes-Oxley Act. Sarbanes-Oxley required the SEC to conduct a study on the adoption of a principles-based accounting system by United States SEC companies. The conclusion reached by the Study is that the adoption of objectives-oriented, principles-based accounting standards in the United States would be consistent with the vision of reform that was the basis of the Sarbanes-Oxley Act. Unlike a pure principles-based system, an objectives-oriented, principles-based system has certain attributes as follows:
1. In applying a particular standard in practice, accountants and auditors focus the accounting and attestation decisions on fulfilling the accounting objective of the standard. This minimizes the opportunities for financial engineering designed to evade the intent of the standard.
2. Each standard is drafted with objectives set by an overarching, coherent conceptual framework meant to unify the accounting system as a whole.
3. The objectives-oriented approach has exceptions which are contrary to a pure principles-based system.
4. The objectives-oriented approach has bright-line tests, which are contrary to a pure principles-based system.
5. The objectives-oriented approach articulates the class of transactions to which they apply and contain sufficiently detailed guidance so that preparers and auditors have a structure in which to determine the appropriate accounting for company transactions.
A hybrid system such as the objectives-oriented, principles-based system could work, if appropriate implementation guidance were given. However, a pure principles-based system will never work. Accounting without a rules-based system is gray, not black and white. A system based on gray, nebulous rules is subject to dispute, confusion, and ambiguity. It also lacks consistency. Consider two companies in the same industry. Using principles-based accounting, one company interprets the timing of revenue recognition in one manner, while the other interprets it in another. Both entities reached their conclusions correctly based on valid assumptions. Yet, the system results in two entities within the same industry, with the same information, reaching different conclusions about how to recognize revenue. The result is a lack of consistency within the same industry.
Let’s also consider the impact of a principles-based system on auditors and accountants in litigation. It is difficult enough trying to defend and define the complex accounting rules under which accountants and auditors now practice. Imagine what would happen without accounting rules and how one could explain to a lay jury, conclusions reached using a principles-based approach.
Finally, the only way a principles-based system could ever work is if it operates within a universally ethical foundation. Although most accountants and their clients do follow an ethical compass, there are simply too many external forces and pressures that could persuade companies, and even their auditors and accountants, to interpret principles in one direction versus another. Such a result would mitigate the benefits expected to be derived from a principles-based system.
This article was an excerpt from Steven Fustolo's course 2012 Current Developments Update: Accounting & Financial Reporting.