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. How they report these statements depends on where they are and what set method they follow.
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.
But what is the difference between the two? Here, we look at how the two differ and why they are important.
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 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.
The Generally Accepted Accounting Principles (GAAP) system is a 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:
- Sincerity with an accurate representation of the company's financial situation
- Permanence of methods
- No expectation of compensation
- Prudence with no semblance of speculation
- Dividing entries across appropriate periods of time
- Full disclosure in all financial reporting
- 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.
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.
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 110 countries that use IFRS as their accounting standards, while the U.S. uses the rules-based GAAP method. That means 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. That was the case for Enron and WorldCom.
In 2001, Enron shareholders lost almost $75 billion in value after the company kept its major debts off of its balance sheets. The company ended up filing for bankruptcy.
An internal audit found billions of dollars in fraud at WorldCom in 2002, where assets were inflated by as much as $11 billion. Fake accounting entries were found, along with inflated revenues.
The Bottom Line
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.