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Principles-based Accounting vs. Rules-based Accounting

Almost all companies are required to prepare their financial statements as set out by the Financial Accounting Standards Board (FASB), whose standards are generally principles-based. Recently, there has been much debate on whether principles-based accounting would be more efficient than the popular rules-based accounting, especially in the context of accounting scandals, such as Enron and Worldcom.

Rules-based accounting is basically a list of detailed rules that must be followed when preparing financial statements. Many accountants favor the prospect of using rules-based standards because in the absence of rules they could be brought to court if their judgments of the financial statements were incorrect. When there are strict rules that need to be followed, the possibility of lawsuits is diminished. Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management. The complexity of the rules, however, can cause unnecessary complexity in the preparation of financial statements.

Rules-based accounting, such as generally accepted accounting principles (GAAP), is used as a conceptual basis for accountants. A simple set of key objectives are set out to ensure good reporting. Common examples are provided as guidance and explain the objectives. Although some rules are unavoidable, the guidelines or rules set are not meant to be used for every situation. The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes compel managers to manipulate the statements to fit what is compulsory. The problem with principles-based guidelines is that a lack of guidelines can produce unreliable and inconsistent information that makes it difficult to compare one organization to another.

Another factor to consider is the fact that principles-based accounting seems to be the most popular accounting method around the globe. International financial reporting standards (IFRS) system — the most common international accounting standard — is not a rules-based system. Most countries opt for a principles-based system, as it is often better to adjust accounting principles to a company’s transactions rather than adjusting a company’s operations to accounting rules. IFRS states that a company’s financial statements must be understandable, readable, comparable and relevant to current financial transactions.

When contemplating which accounting method is best, make certain that the information provided in the financial statements is relevant, reliable and comparable across reporting periods and entities. Increased discussion has pushed accountants towards principle-based accounting, but it is recognized that the method needs to be modified to make it more effective and efficient.

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