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Introduction

The purpose of this paper is to critically assess whether the use of principle-
based accounting standards helps or hinders the decision making process for users
of financial statements in the context of an appropriate accounting theory.

After a rash of accounting scandals such as the cases involving Enron and
WorldCom in the United States, the truthfulness of corporate accounting numbers
has become a controversial issue. The issue whether corporate financial statements
can objectively reflect the underlying reality of corporate transactions has attracted
much attention from accounting regulators i.e FASB and IASB. This issue deserves
greater attention given the current heated controversy over principle and rule based
accounting standards(Foster and Johnson, 2001).There are rapid increases in calls
for a move toward principle based accounting standards. Some experts who support
the use of the principle based standard argue that the rule-based approach was
behind the Enron scandal and have subsequently criticised this, contending that
there are weaknesses in the way it deals with some of the issues involved in the
preparation of financial statements.

The capital markets, at the present time, rely mostly on trust; where the accuracy is
imagined to be true, based on the financial information, and where the reality in
economy is reflected. The financial information or statements are then examined by
the company whether it is reasonable or not, and the assurance of the statements to
be true and fair is decided in accordance with the Generally Accepted Accounting
Principles (GAAP). This opens the door to what would be the appropriate accounting
system of companies in America; the Rules-Based or the Principle-Based
Accounting Principles (Psaros and Trotman, 2004).

Rules-Based Accounting Principle

Rule based accounting came into existence in order to provide definite accounting
treatment for a particular transaction. In this type of accounting, certain rules have
been established which act as the standards. There are a number of rules in this
approach. As many different types of transaction are taking place daily, some of
which are relatively unique in nature and therefore a large number will fail to comply
with these rules (Foster and Johnson, 2001). The rule based standards are
meticulously detailed and consequently, in order to implement these standards,
guidance becomes the key factor. Firstly, in this very detailed rule based system, all
possible contingencies are investigated and then, the best possible accounting
treatment will be selected. Often this detailed rule based system is known as 'expert
system' as the knowledge of experts, in this cases the accountants or the auditors,
has been converted into a particular rule. The key idea for this is to make it easier to
deal with a similar transaction in the future based on previous observation. The
bright line test for treating the exceptions are exercised widely in the detailed rules
based accounting principle (West, 2003)

Principles-Based Accounting Principle

It is argued principle based accounting helps to generate more understandable


financial statements for the stakeholders of a company. The use of 'professional
judgement' allows the auditors or the accountants to cope with new unique economic
transactions (Accounting Standards Board,1999). Objectiveness is an essential part
of the principle based accounting system and as such has been clearly defined;
therefore the possibility of exception reduces dramatically. The principle based
accounting system is widely recognised as the source of consistent standards. And
consequently, the stakeholder can enjoy extensive comparability in financial
statements. The economic reality of a transaction has to be reflected in principle
based accounting. The attitude of 'substance over form' should be maintained
throughout the process of preparing financial reports under principle based
standards (Kershaw,2005).

A significant benefit of principle based accounting can be shown in its broad


guidelines which can be applied to various situations. Broad principles can avoid the
drawback associated with particular requirements that allow some contracts to be
prepared specifically to manipulate their purpose. Evidence has been found in a
previous study done by FASB that to avoid gaining additional liabilities
managements purposefully tend to structure leases as operating leases. Therefore,
providing broad guidelines could enhance the representational accuracy of financial
statements (Nobes,2005).

Furthermore, principles-based accounting standards permit accountants to use their


professional judgment in order to assess the substance of transactions. This
approach significantly differs from the underlying "box-ticking" approach which is
common in the rules-based accounting standards. FASB Chairman Robert Herz has
claimed that using professional judgment rather than relying on comprehensive rules
could improve the professionalism of financial statements (Financial Accounting
Standards Board and International Accounting Standards Board,2009).
Another benefit of a principles-based approach is that it may result in simpler
standards. Herz has stated that the way of presenting financial statements in the
principles-based approach would turn a hundred pages into twelve pages in the
rules-based approach . Principles would be easier to understand and could be
applied to a broad range of transactions. Harvey Pitt, former SEC chairman,
explained this as follows: "Because standards are developed based on rules ... they
are insufficiently flexible to accommodate future developments in the marketplace.
This has resulted in accounting for unanticipated transactions that is less
transparent.". At last, the use of principles-based accounting standards can provide
accounting statements that more accurately reflect a company's actual performance.

For non-professional users "potential shareholders', the principles-based approach


can assist them to more accurately decide whether to invest in a company or not by
showing them the accurate financial statements. This can be achieved by applying
the professional judgments which will result in avoiding misleading financial
statements being approved (Psaros and Trotman, 2004). A clear example of this
situation is the Enron scandal where the shareholders lost over 50 billion dollars after
being mislead by the directors of Enron and the 'box-ticking' approach could not
protect them from management manipulation by not allowing accountants to utilise
their professional judgments. Broad principles and professional judgment could have
prevented the Enron failure before it happened (Kershaw,2005).

Principle based approach assists investors in providing a "true and fair" view of
financial statements. Principle based approach is oriented more towards positive
accounting theory whereas the rule based system resembles more of the normative
theory. Moreover, the chairman of the IASB Sir Tweedie (2002) states that for a
principle based approach to be effective and efficient it will require both auditors and
preparers to work together by complementing each other in order to reflect the
economic substance of transactions in financial statements (Jamal and Tan 2010,
accounting review).

However, there are many drawbacks of the principle based approach and one of the
major ones surrounds the contingent liability standard. Due to a lack of precise
accurate guidelines this could lead to inconsistencies in the application of standards
across businesses (Psaros and Trotman, 2004) . For example, organisations are
needed to recognise a liability along with an expense in regard to a contingent
liability that is probable and estimable. However, a contingent liability that is
reasonably estimable is accounted in the footnotes. As a result this will lead to
problems for businesses in deciding if liabilities are probable or merely reasonably
possible without the aid of any exact guidelines to follow (Shortridge & Myring,
2004).

The reason why the principle based system is favoured over rules based is because
the rules approach establishes a sequence of "bright lines" which leads to people
playing the system at the cost of the relevant principle. For instance, fixed
percentages within standards can be by- passed easily, hence it is prone to
manipulation and creative accounting which leads to a unfaithful representation of
accounts. What's more, the rule based method is seen as being extremely detailed
through standards approaching hundreds of pages therefore this leads to complexity.
As the primary aim of the principle method is to create simpler standards for the
users understanding in terms of financial statements (The Institute of Chartered
Accountants of Scotland).

Another problem with the principle based approach is that the author provides no
guidance on how rules should be interpreted and implemented in practice. As the
IASB and FASB are aiming towards a more principle based approach and planning
to make future accounting standards less rules based. For this reason, converged
standards will normally hold less implementation and interpretation guidance. This
will lead to converged standards containing less bright line tests, exceptions and anti
abuse provisions (Pounder, 2009)

The rule based approach has been criticised on many occasions for presenting
management opportunities to discover loopholes in the rules so they can manipulate
the financial information which leads to creative accounting.

Rules based accounting is guided by bright line tests. For example, the rule based
GAAP treat on the basis of bright line test. Many claim that US has the most
complicated system of treating lease. In the system of US, as described in Heffes
(2006) "if the present value of lease payments equals 90 percent or more, then it is a
capital lease; if it's 89.5 percent, it's an operating lease." This means an opportunistic
manager can take the advantage of a certain rule and easily engineer the transaction
to make a capital lease into an operating lease. The chance of manipulation
becomes substantially higher with the rule based accounting system.
The detailed rules based accounting system give guidelines to the auditors and the
accountants; therefore the litigation risk is much less than the principle based
accounting system. As described in Schipper (2003), many claim that sometimes
auditors feel more comfortable working with a detailed guideline. Again, it can be
argued that it actually underestimates the skill and professional judgement of the
auditors and the accountants. Another bright side of rule based accounting is
comparability. As the auditors actually abide by the detailed rules and structures,
chances of volatility is reduced in the financial reports. On the other hand,
professional judgement in the principle system can generate different types of a
particular result.
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