Principles vs Rules

Author: 饮鸩止渴

There are two prevailing accounting standard setting approaches today, the principles-based approach and the rules-based approach. The dispute between the two has been going for decades. While both have some unique merits compared to the other, it seems that, in response to the famous accounting scandal of Enron Corporation in 2001 and many similar cases afterwards, the rules approach has lost superiority to its principles-based counterpart. In this essay, current issues related to these two accounting standard setting perspectives will be addressed. By comparing the principles approach to the rules approach in some sensible accounting areas, the claim of the International Accounting Standards Board (IASB) that principles-based international accounting standards are better than rules-based standards is justified. Besides, the existing problems in principles-based accounting standards, especially the comparability problem caused by multi-interpretation, will be examined.

Principles-based accounting standards and rules-based accounting standards, although both appear as a group of concepts and regulations, have obvious differences in nature. According to Nelson, accounting rules are defined as “special criteria, ‘bright line’ threshold, examples, scope restrictions, exceptions, subsequent precedents, implementation guidance, etc” (cited in Haswell 2006, pp. 50-1). Accounting principles are more about concise statements and definitions of financial reporting elements (Haswell 2006, p. 51). Simply stated, principles create broad guidelines which could be applied to many cases, while rules-based accounting provides a list of detailed rules, trying to address every possible situation specifically and clearly. Given this, rules-based accounting standards are often much longer and more complex than those of principles-based. On the other hand, principles-based standards require a lot more judgments by accounting professions, since principles only provide general guidance and allow more alternatives of conducts under different circumstances. That is, principles-based accounting is more flexible than rules-based accounting (Doupnik & Perera 2005, p. 118).

The current representatives of rules-based standards and principles-based standards are the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS), respectively. The former, set by the Financial Accounting Standards Board (FASB), is used in the United States and some other countries, while the latter, introduced by the IASB, has been discussed for sometime and will be applied by all European Union countries gradually in the following years.

Notably, after the scandal of Enron, criticisms of rules-based GAAP have become severe and an increasing number of people in the United States have been appealing to replace the current rules-based approach to setting accounting standards with principles-based standards. The Securities and Exchange Commission (SEC) then released an “objectives-oriented” study required by the Sarbanes-Oxley Act of 2002, addressing the feasibility of a principles-based accounting system (Shortridge & Myring 2004, para. 2). In this study, using a principles-based approach was strongly recommended (Burns 2003), which may indicate a trend of moving from rules to principles through out the accounting world.