Nearly 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. FASB uses these principles in establishing its accounting practices and methods. Law requires U.S. companies to adhere to accounting standards when reporting their financial statements, but the specifics can vary depending on where a company is headquartered.

Key Takeaways

  • Nearly all companies are required to prepare their financial statements as set out by FASB, whose standards are generally principles-based.
  • The rules-based Generally Accepted Accounting Principles (GAAP) system is the accounting method used in the United States.
  • Critics of principles-based accounting systems say they give companies too much freedom in reporting.
  • On the other hand, critics of rules-based methods like GAAP cite that the system can often be too complex.

Understanding Principles-Based Accounting

Principles-based accounting seems to be the most popular accounting method around the globe. 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.

The international financial reporting standards (IFRS) system—the most common international accounting standard—is not a rules-based system. The IFRS states that a company’s financial statements must be understandable, readable, comparable, and relevant to current financial transactions.

Rules-Based Accounting

Rules-based accounting is a standardized process of reporting financial statements. The Generally Accepted Accounting Principles (GAAP) system is the rules-based accounting method used in the United States. Companies and their accountants must adhere to the rules when they compile their financial statements. These allow investors an easy way to compare the financial information of different companies.

There are 10 principles of the rules-based GAAP accounting system:

  1. Regularity
  2. Consistency
  3. Sincerity with an accurate representation of the company's financial situation
  4. Permanence of methods
  5. No expectation of compensation
  6. Prudence with no semblance of speculation
  7. Continuity
  8. Dividing entries across appropriate periods of time
  9. Full disclosure in all financial reporting
  10. Good faith and honesty in all transactions

The GAAP method is used when a company releases its financial statements to the public. It covers a number of things such as revenue recognition, balance sheet classification, and how outstanding shares are measured.

Companies and accountants that do not follow GAAP standards could be brought to court if their judgments and reporting of the financial statements were incorrect.

Principles-Based vs. Rules-Based Accounting

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.

On the other hand, when there are strict rules that need to be followed, like those in the U.S. GAAP system, 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.

Compliance to GAAP helps to ensure transparency in the financial reporting process by standardizing the various methods, terminology, definitions, and financial ratios. For example, GAAP allows investors to compare the financial statements of two companies by having standardized reporting methods. Companies must formulate their balance sheet, income statement, and cash flow statement in the same manner, so that they can be more easily evaluated.

If companies were able to report their financial numbers in any manner they chose, investors would be open to risk. Without a rules-based accounting system, companies could report only the numbers that made them appear financially successful while avoiding reporting any negative news or losses.

Problems With Both Systems

The main problem overall is that there is no one set accounting method that has been universally adopted. There are currently more than 144 jurisdictions that use IFRS as their accounting standards, while the U.S. uses the rules-based GAAP method. As a result, investments, acquisitions, and mergers may require a different lens when comparing international competitors such as Exxon and BP, which use different accounting methods.

Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency. They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of its financial health.

In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. And having strict rules means that accountants may try to make their companies more profitable than they actually are because of the responsibility to their shareholders.

Example of Accounting Manipulation

Enron was a major energy company in the 1990s. In 2001, Enron shareholders lost almost $75 billion in value after the company's executives used fraudulent accounting practices to overstate revenue while hiding debt in its subsidiaries.

Enron declared bankruptcy–and with $63 billion in assets–was the largest U.S. bankruptcy at that time. The company's collapse sent shockwaves throughout the financial markets leading to a wave of additional regulations.

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. Although there are benefits to principle-based accounting, it is recognized that the method may need to be modified to make it more effective and efficient.