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Which is Better – Principles or Rules?

April 5, 2011

When it comes to accounting standards, there is debate about whether principles or rules are better. Some argue that the rules based US GAAP approach is better while others argue that the principles based IFRS is better. But which approach, principles or rules, do you think is best?

While US GAAP is often considered rules based, it is better to think about individual standards within US GAAP as being more or less rules-based. There are advantages and disadvantages to a rules based approach. Advantages include clarity in application, reduction of risk (but only when the applicable rule is followed), and comparability for companies in the same industry for the same rule. Disadvantages include a regimented approach where a transaction must be accounted for in accordance with the rule even if the applied accounting is misleading, non-comparability between different industries when the transactions are similar, and increased risk when the applicable rule is not followed (its hard to defend a position when the rule is broken).

Similarly, IFRS is often thought of as principles based, but is better considered more or less principles based. Clearly defined principles provide many advantages as a basis of accounting, including allowing preparers the ability to consider the best way to account for and report a transaction, increased comparability among companies with similar transactions no matter the industry and the ability to defend positions based on the principles followed. Disadvantages include an increased ability to manipulate transactional accounting, increased variations in accounting approaches for similar transactions, and fewer bright lines to consider in determining how to account for a transaction.

In today’s global marketplace IFRS has a distinct advantage over US GAAP. The fact is that IFRS is either permitted or required in over 120 jurisdictions while US GAAP is required in one. The SEC will decide later this year when, whether and how IFRS should be adopted in the United States. If IFRS is permitted or required in the United States, companies will need to develop a judgment framework that documents how accounting decisions will be made in a principles based accounting environment. Because there could be variations in accounting by different companies for similar transactions, companies should disclose the basis for the accounting followed as well as the factors considered and reasons for accounting decisions made.

If you could choose to follow accounting standards that are principles based or rules based, which would you choose?

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5 Comments leave one →
  1. August 21, 2011 1:19 pm

    I prefer clear atomic rules over principles. Principles can act as guidelines on how to conduct reporting but rules clearly delineate what is and is not allowed. It’s not that I dislike principles, for they are the broad basis on which individual rules are derived. I do believe that a broad basis lends itself to more interpretation than actual execution, which is a disadvantage when it comes to litigation. More to the point, the majority are not sophisticated enough to think critically about principles. It is far more productive to have them attack or defend based on rules.

  2. Cliff Beacham permalink
    January 9, 2012 6:54 pm

    Rules and form are what got us into this mess. Rules just set the boundaries that companies work around (Ref Enron). A principle has no boundary. However, IFRS is not without rules as US GAAP is not without principles. Some things cannot be expressed as a clear line anyway – such as probability – it is nice to say 60% (or whatever %) but how do you measure probability – the new approach is needed. Again it is going to happen whether we like it or not so we had better prepare for it. I’m sorry you don’t like it but, hey, they did not ask me either. Disclosed policies are a way of communicating the basis of our judgements and how we calculate amounts etc. Don’t forget the EU has been using IFRS since 2005.

  3. Jeff Henson permalink
    January 16, 2012 3:02 pm

    I tend to favor principles over rules, but agree it can’t be exclusively one without some of the other. I think a good solution is to be guided by principles with rules in certain important areas (I’ll let smarter people than I determine where rules should apply). If Principles is the general approach, then significant disclosure requirements should be enforced to help investors understand the principles underlying management and accounting decisions and the impact those principles based decisions have had on financeial statement and footnote disclosures.

    I don’t oppose IFRS, but I do think if IFRS is the standard we go to globally, that we need to diligently eliminate all of the many “flavors” of IFRS that are being used in jurisdictions around the world.

    Jeff

  4. Donna Casey permalink
    February 11, 2012 1:08 pm

    In essence, isn’t what IFRS is now what US GAAP was before all the rules came to be?

  5. Jeff Henson permalink
    February 11, 2012 1:47 pm

    I agree with what you are saying in substance. At the risk of revealing my lack of youth, I can remember when US GAAP was principles based. I long for the return of principles as the basis for deciding how to best reflect the nature and substance of business transactions. It is important to note however, that there is a need for a solid decision framework is the basis for those principles based decisions. That the decision framework can only yield the best decisions if it is based on sound, ethical and moral standards that have stood the test of time.

    I wonder how many leaders in business are calling for or have established a decision framework for their organizations.

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