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 principle-based accounting would be more efficient than the popular rules-based accounting - especially in response to accounting scandals, such as Enron and Worldcom, the current way of accounting has been under a great deal of criticism.

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 rules, however, can cause unnecessary complexity in the preparation of financial statements.

Principles-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 lack of guidelines can produce unreliable and inconsistent information that makes it difficult to compare one organization to another.

When contemplating which accounting method is best, it must be made 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.

For further reading, see What Enron Taught Us About Retirement Plans and Cooking The Books 101.

  1. Do all countries follow the same GAAP?

    Learn about GAAP and IFRS accounting standards, and understand the difficulties in having a basic set of accounting principles ... Read Answer >>
  2. How does financial accounting help decision making?

    Read a brief overview of some areas where financial accounting helps in decision making for investors, lending institutions ... Read Answer >>
  3. What are the main objectives of cost accounting?

    Learn about the main benefits of cost accounting systems, why they are different from financial accounting and why they are ... Read Answer >>
  4. When and why were GAAP first established?

    Take a deeper look into the development and purpose of the generally accepted accounting principles, also known as GAAP, ... Read Answer >>
  5. What are the differences between a change in accounting principle and a change in ...

    Learn how to differentiate between a change in accounting principle and a change in accounting estimate and how accountants ... Read Answer >>
  6. How does the Financial Accounting Standards Board (FASB) establish accounting protocol?

    Find out how the Financial Accounting Standards Board or FASB, identifies possible financial reporting issues and determines ... Read Answer >>
Related Articles
  1. Investing

    International Financial Reporting Standards (IFRS)

    International Financial Reporting Standards are accounting rules and guidelines governing the reporting of different types of accounting transactions.
  2. Investing

    The Impact Of Combining The U.S. GAAP And IFRS

    The convergence of accounting standards is changing the attitudes of CPAs and CFOs toward harmonization of international accounting.
  3. Investing

    What is Accounting?

    Accounting is the recording of financial transactions of a business or organization. It also includes the process of summarizing, analyzing and reporting these transactions in financial statements.
  4. Investing

    What are Financial Statements?

    Financial statements are a picture of a company’s financial health for a given period of time at a given point in time. The statements provide a collection of data about a company’s financial ...
  5. Managing Wealth

    Accounting Research Manager: Career Path & Qualifications

    Discover the basic responsibilities of an accounting research manager, the path this career usually takes and the qualifications needed for this career.
  6. Managing Wealth

    Accounting Research Manager: Career Path & Qualifications

    Discover the basic responsibilities of an accounting research manager, the path this career usually takes and the qualifications needed for this career.
  7. Investing

    12 Things You Need To Know About Financial Statements

    Discover how to keep score of companies to increase your chances of choosing a winner.
  8. Investing

    Why Financial Statements Are Harder to Read Than Ever Before

    Understand four major reasons that financial statements published in 2016 are more complicated and difficult to read than they were in the past.
  9. Investing

    Financial History: The Rise Of Modern Accounting

    Find out how these two have grown hand-in-hand throughout our modern history.
  10. Personal Finance

    Career Advice: Financial Analyst Vs. Accountant

    Read an in-depth comparison between a career as a financial analyst and a career as an accountant, including how to determine which is best for you.
  1. Accounting Standard

    A principle that guides and standardizes accounting practices. ...
  2. Account Statement

    A periodic summary of account activity with a beginning date ...
  3. Accounting Theory

    Assumptions, methodologies and frameworks used in the study and ...
  4. Chart Of Accounts

    A listing of each account a company owns, along with the account ...
  5. Financial Accounting

    The process of recording, summarizing and reporting the myriad ...
  6. Accounting Interpretation

    A statement clarifying how accounting standards should be applied. ...
Hot Definitions
  1. Perkins Loan

    A loan program that provides low-interest student loans to undergraduate and graduate students who demonstrate exceptional ...
  2. Wealth Management

    A high-level professional service that combines financial/investment advice, accounting/tax services, retirement planning ...
  3. Assets Under Management - AUM

    The market value of assets that an investment company manages on behalf of investors. Assets under management (AUM) is looked ...
  4. Subprime Auto Loan

    A type of auto loan approved for people with substandard credit scores or limited credit histories. There is no official ...
  5. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  6. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
Trading Center