Rule Base and Principle Base Accounting Standard Essay Example

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As per legal theorists' understanding, a clear distinction is made between rules and principles grounded on the degree of detail and measure of judgement necessary (Wustemann and Wustemann, 2010). To illustrate, Braithwaite (2002) suggests that principles correspond to ambiguous directives while rules correlate to detailed ones. In a similar vein, Cunningham (2007) proposes that principles are undefined as they offer little predictive guidance; contrarily, rules are extremely explicit as they provide substantial advance guidance. Furthermore, he purports that the application of principles necessitates the decision maker's judgement, whereas rules provide scant space for judgement.

The accounting literature typically aligns with the definitions given in the legal texts: various accounting academics and regulatory bodies portray rules as incredibly detailed, clearly outlining precise accounting procedures for particular transactions or events. Meanwhile, principles are viewed as broad guidelines requiring a judgment on the accounting matter in focus, instead of stipulating the specifics of implementing these principles (Psaros, 2007).

While both legal and accounting literature tend to agree on their definitions, certain industry-specific considerations do exist within the accounting framework. For example, certain scholars argue that accounting guidelines often possess quantitative limits (often referred to as "bright-lines" in the realm of accounting), exemptions, and occasional inconsistencies. Conversely, some suggest these principles stem from a complete and consistent conceptual framework (Bonham et al., 2009). Incorporating these supplementary descriptions from a legal perspective, one finds that rules do not inherently contain quantitative constraints, exceptions, or inconsistencies. Furthermore, these rules may also be sourced from an array of internally consistent high-level objectives (Wustemann and Wustemann, 2010).

The need for additional definitions signifies perceived shortcomings in U.S. standards.

These standards have become so exacting that some believe they encourage corporations to exploit ambiguities, something the accounting literature aims to rectify by advocating for a principles-based approach. This could illuminate why the rules-based approach to setting standards has lost favor, particularly in the wake of corporate accountancy scandals such as those involving Enron, World Com, and several others in 2002 and intermittent ones throughout the decade like Parmalat in 2003, AIG in 2004, Lehman Brothers in 2009, Olympus in 2011, etc (Refer to Appendix).

Using the example of leases, one can distinguish between rules and principles. In Canadian accounting standards, it is specified that a lease may be capitalized if it's believed that "substantially all the benefits and risks of ownership" have been received by the lessee. There are three conditions to determine whether these advantages and risks have been completely transferred. Conversely, according to US standard, capitalization of a lease is mandatory if any (erroneously referred as four instead of three) of these conditions are met; otherwise, it should be treated as an expense. It's noteworthy that under Canadian standards, even when none of the conditions are fulfilled, accountants still have the flexibility to capitalize the lease based on transactional essence. Thus, while US standards adhere to a rules-based system, Canadian standards follow a principles-based approach (Beechy, 2005).

In conclusion, despite there being variations in legal and accounting interpretations of rules and principles, they tend to concur that principles serve as extensive guidelines that standard users depend on while utilizing professional judgment. Our demonstration with principles-based standards illustrated that the standard's intent is of paramount significance to its user. In contrast,

rules necessitate the standard user to adhere to specific guidance when determining the event's accounting treatment. Therefore, a rules-based methodology maintains a legal emphasis.

Examining the contrast between standards based on rules versus principles

This segment will delve into the pros and cons of standards based on rules and principles, as emphasized in various references. We will explore various aspects including professional discretion (allowance for inventive accounting and representation of economic facts), enforcement, uniformity / coherence, and intricacy.

Expert Opinion: Financial Truth vs. Innovative Bookkeeping

Often, the idea is put forward that when properly utilized, professional judgment - which is greatly permitted in principles-based accounting standards - enables adherence to the standards' purpose, proposes accounting approaches for unique or individual situations not anticipated by rules-based standards (Cunningham, 2007), and is better responsive to shifts in business methods (Kivi et al, 2004).

Furthermore, the highest quality information explaining the company's economic situation and its accounting can be obtained from accountants and managers using professional judgment. Kivi et al (2004) indeed posit that the best argument for principle-based standards is the accurate depiction of a company's economic reality, thanks to professional judgment. For instance, as shown in the operating leases example, it may sometimes be necessary to employ professional judgment when rules obstruct economic substance. By choosing specific accounting treatments and utilizing professional judgment, managers can divulge confidential data to financial markets which allow investors, in line with Akerloff's analogy, to differentiate commendable firms from the less desirable ones - the "lemons". The signaling advantage of using professional judgment has been underlined by Hail et al. (2009).

Beechy (2005) presents a

contrasting viewpoint, stating that managers, despite their best intentions, might not succeed in making necessary professional decisions due to inherent biases. These biases stem from various sources, such as the pressure to display short-term success, that is, to meet and exceed analyst predictions to prevent a decrease in stock price. Additionally, when a manager's recompense is tied to the company's performance or given as stock options, bias becomes more probable (Guenther, 2005).

In the aftermath of numerous corporate scandals in the early 2000s, it's hardly surprising to discover cases where business leaders had dishonest intentions. Accordingly, standards based on principles that rely on professional judgment often come under scrutiny for potentially enabling earnings manipulation and creative accounting techniques. On the other hand, research indicates that rule-based standards could alleviate such financial misrepresentation (Benston et al., 2006, Ng, 2004). Ewert and Wagenhofer (2005) suggest that more stringent rules actually increase the probability of legitimate earnings management - this means changing aspects of transactions or events to avoid specific account treatments dictated by rule-based standards. However, this type of genuine earnings management carries a significant cost to shareholder value due to missed profitable NPV projects, lack of investment in R&D among other harmful effects.

Nelson et al's seminal work in 2002 indicated that corporations tend to resort to real earnings manipulation when the standards are stringent and provide no room for interpretation. Such alterations in operational aspects often go unnoticed by auditors when decision-making aligns with exhaustive regulations. Conversely, companies tend to exploit the flexibility provided by less stringent standards, managing their earnings. Owing to the ambiguity of the rules, auditors are prone to concur

with the accounting methodologies adopted by these firms. This suggests that, regardless of whether the standards are explicitly defined or loosely structured, managers with an intent to control their earnings can navigate around them.

Enforceability

The primary disadvantage of principles-based standards as opposed to rules-based standards, especially in litigation-happy cultures like the US, concerns their implementation. Making sure these standards are adhered to is difficult due to their ambiguity and allowance for multiple accounting methods for identical transactions (Cunningham, 2007). At the same time, entities that establish principle-based standards face an increased likelihood of legal proceedings, as regulatory authorities could claim violations even when choices were made conscientiously and genuinely (Dickey and Scanlon, 2006).

There is a contention that, despite having principles-based standards, Germany observes a lower frequency of litigation cases barring tax matters, when contrasted with the US. Krahnen and Schmidt (2004) posit this could be attributable to Germany's lack of robust enforcement and surveillance practices equivalent to the US Security Exchange Commission. As a result, the transition to a principles-based system in the US might precipitate a rise in litigation cases (Hail et al, 2009). On the other hand, advocates of the rules-based approach believe that lawsuits may decrease provided practitioners strictly adhere to its exact guidelines.

Similarity and uniformity

A crucial element in comparing principles-based and rules-based accounting systems revolves around their potential for standardization and uniformity. Choi and McCarthy (2003) suggested that standardization holds significant importance in the realm of accounting, greatly desired by financial markets and regulatory bodies. For example, European laws related to the application of IFRS strive to maintain a consistent use of

consolidation procedures. In general, it has been found that rules-based standards have a greater likelihood for standardization as they are clear cut and typically do not lead to discrepancies in dealing with identical transactions, unlike principles-based standards (Dickey and Scanlon, 2006).

Despite compliance with standardized accounting standards, especially those that are rules-based, it's difficult to unequivocally assert that a corporation with higher earnings is necessarily in a better position than one with lesser earnings. This viewpoint can be comprehended by examining one of the principles for recognizing liabilities - an obligation is only recognized when the likelihood of expense surpasses 50%. Imagine two companies facing impending litigation, where one has a 4% probability and the other has a 40% probability of financial payment. Neither company would record this liability, hence presenting similar profits despite their different financial conditions (Wustemann and Wustemann, 2010).

Intricacy

Compared to the rules-based method, the principles-based accounting system denotes straightforwardness, as it is simpler to comprehend and applicable to a broader suite of transactions. A study conducted by Ng (2004) recommended that if U.S. accounting norms gravitate more towards a principles-based strategy, the GAAP volume would be dramatically shrunk. An interview with Business Week in 2002 revealed FASB Chair Robert Herz's belief that a principles-based process could result in standards that are shorter than 12 pages, as opposed to over 100 pages (Shortridge and Myring, 2004). However, a rules-based system's throughput can be hampered due to its complexity. Conversely, real-life cases can be more intricate, and some sectors like the financial industry demand robust regulation for efficient, orderly operations. Hence, inventive accounting stemming from variedly interpreted principles and

potential loopholes might not be systematically sound or accurate in such scenarios (Weetman et al, 2006).

Final Thoughts

In conclusion, the prevalent corporate accounting scams over a span of ten years were largely attributed to rules-based accounting standards. The transition towards adopting principles-oriented standards in US was widely acknowledged by academics and regulators as necessary. In order to evaluate whether this shift effectively addresses the issue of dishonest accounting, we initially distinguished rules-based accounting standards from principles-based standards on the basis of specificity degree and judgment level according to legal literature. Additionally, this distinction was made considering the unique bright-lines, occasional exceptions and potential inconsistencies as highlighted by accounting literature.

Afterwards, we assessed the advantages and disadvantages of two divergent standards based on multiple factors. The professional judgement approach suggests that principle-oriented standards accurately depict the economic scenario, convey confidential information to investors, and can be broadly applied in specific situations. However, if those preparing these documents have bad intentions, they could cunningly bypass regulations regardless of the imposed standard. It was argued that a rule-centered system's strengths lie in its enforceability and comparability while simplicity is considered an asset of a principles-driven system. Nonetheless, there might occur scenarios where comparability isn't achieved or complex standards may become necessary.

One could conclude that a spectrum of options exists between rules-based and principles-based strategies, foregoing the binary categorization, this should embrace the best elements from each approach.