Approaches to Accounting Standards Setting

Introduction

The need to set and improve efficient accounting standards was caused by the global economic crisis in 2008, which led to the creation of methods to regulate markets and financial institutions. In the process, accounting becomes an economic good since it raises the compliance costs of an organization. Managers of the companies use accounting rules to improve their capability to monitor and control their and employees’ actions (Papadopoulo 2011).

In theory, financial reporting and accounting are apolitical and neutral, but setting of accounting standards is influenced by the external groups who hold varied interests (Papadopoulo 2011). Literature provides evidence that the standard setter of accounting is either an independent organization or a regulator like the government. The approaches used by these two classes of setters determine the type of the method used to implement accounting standards. This research will analyze the various approaches to standards of setting as provided by literature.

In the U.K., the accounting standard setters are Accounting Standards Board (ASB) offering accounting standards known as FRSs or “Financial Reporting Standards”, which include FRSSE (Financial Reporting Standard for Smaller Entities) and FREDs (Financial Reporting Exposure Drafts) from the 1990s (Laureen et al. 2003, p.1). Prior to these standards, the market was under the control of SSAPs (Statements of Standards Accounting Practice), which issued ICAEW, and are still in effect today (Laureen et al. 2003, p.1). Another accounting setting force is UITF abstracts (Urgent Issues Task Force abstracts) that assist ASB through the investigation of areas of accounting conflict or unsatisfactory interpretation of company’s accounts (Laureen et al. 2003, p.1).

In addition, there is GAAP (Generally Accepted Accounting Practice) which refers to “rules generally accepted as being applicable to accounting practice as laid down by standards, legislation or upheld by the accounting profession” (Laureen et al. 2003, p.5). The setting approaches used by ASB for accounting standards in the U.K. are of a great interest in this analysis.

Setting Accounting Standards: Principle- Vs. Rule-Based Approach

Approaches to setting and regulation of accounting standards are either rule- and principle-based. The idea behind principles-based standard is that application of concepts rather than standards formulated is based on certain rules, which leave alternatives and many exceptions, thus raising questions about their coherence (Laureen et al. 2003, p.2). It is important to realize that the format of the accounting standard depends on the content of what the standard seeks to regulate (Benston, Bromwich, and Wagenhofer 2006).

In September 2007, the Securities and Exchange Committee (SEC) formed a committee that would oversee the simplification of Financial Reporting Systems. Their aim was to make it more user friendly to investors. In their quest to reform the system, they devised a three-way approach to tackle the issue. First, it was necessary to redress the existing accounting standards, which were considered very complex, by rewriting them all over, or, by doing away with them completely (Hronsky and Houghton 2001). The second course of action included three initiatives, which comprised of a comprehensive codification, which would be in application for everyone using the Generally Accepted Accounting Principles (Laureen et al. 2003).

The second initiative was to consolidate sources of standards which contributed to ASB, while the final goal was to develop standards that would be objective-oriented or principles-based for the further use (Schroeder, Clark, and Cathey 2001). These accounting standards were written in a manner so that an accountant would focus his/her attention on achieving accounting objectives implemented in the standards rather than focusing on complying with the written rules. This means that the report will reflect faithfulness and the economic substance at hand rather than display what the rule wants to see by manipulating the actual performance to adhere to it (Schroeder, Clark and Cathey 2001).

The principle-based approaches depend on high level principles or rules, and need the application of judgment in their setting, while rule-based regulation entails a detailed prescription and a lesser judgment (Ward 2005, p.64). The U.K. has endorsed accounting standards that are based on sound principles rather than on a set of prescribed and detailed rules similar to those used by FASB of the US (Benston 2006). The principle-based approach is the preferred method of setting accounting standards in the U.K. Graham Ward, the IFAC president, stated that “the accounting and auditing professions in the united kingdom and the European Union believe very clearly that the principles-based approach is the right approach” (Ward 2005, p.64).

Moreover, support of the principles-based approach comes from ICAS where the group states that “we support the consensus that only principles-based accounting standards can fully serve both the needs of business and the public interest” (ICAS 2006, p.3). Therefore, unlike the rule-based approach, principles-based one requires auditors and companies to apply set principles responsibly without the intent of skewing economic reality. It is this principle-based approach, which is employed in the development of the accounting standards ISAs and IASs (International Accounting Standards), following the British experience with corporate governance code and off-balance sheet (Benston, Bromwich and Wagenhofer 2006).

An important principle of accounting standards required within the principle-based approach is “true and fair view” (Benston et al. 2006). “Financial statements are described as depicting a fair and true view of, or as presenting fairly, the financial position, performance and changes in financial position of an entity” (Benston et al. 2006). These principles are fundamental in financial reporting, but standard setters define an additional set of rules to increase the quality of financial reports (Arden 1997). Through the addition of “specifications, numerical thresholds, and bright lines, standards become more rule based” (Nelson 2003).

The reason the rule-based approach has come under fire in the recent years derives from the lessons learnt from Enron’s corporate failure where Andersen Arthur was seen “re-designing or accepting client-oriented financial instruments that met the technical requirements of GAAP while violating the intent” (Benston, Bromwich and Wagenhofer 2006). In the process, this apparent loop hole within the rule-based approach gave Andersen an opportunity to carry out misleading accounting procedures, which were revealed by Sarbanes-Oxley Act of 2002 (Benston, Bromwich and Wagenhofer 2006).

An example of an Objective-oriented standard was the Statement of Financial Accounting Standard 141(SFAS 141). SFAS set that only one entity acquired another type of accounting transactions that are referred to as Business Combinations (Laureen et al. 2003). According to the earlier version of the rule-based standards, there were two potential accounting treatment possibilities. First, the purchase accounting method is used, and secondly, the pooling of interests accounting method is implemented as well (Ward 2005).

Taking into account the purchase method of accounting, it entails that company A should consider the purchases of company B as company B’s assets and assume the liabilities of Company B (Hronsky and Houghton 2001). A conspicuous fact for the buying company to consider while using this method is how the assets are valued when undertaking the transfer of ownership. The buying and selling companies agree on the purchase price. The price will go beyond the amount at which the assets were carried on according to the Company B’s balance sheet because these amounts are carried at book value (cost minus depreciation), instead of a Fair Market Value (Benston 2006).

On the other hand, regardless pooling of interests, these two companies are handled simply as if they were merged into one. At this point, it should be noted that it is made as a response to the Exposure Draft 3. This response divides in five sections, but he first section entailing the attributes of “Business Combination’s standards” is of primary importance (ICAS 2006, p.3). The committee recommended standards that were “conceptually-sound and based on economic principles (ICAS 2006, p.3).

The principle-based standard must exhibit the “economic substance, not the form of a transaction and this should act as a guide during financial reporting” (Deegan and Unerman 2006.) Secondly, the standard should describe the particular transaction or the event that is the subject matter or which the standard wishes to cover (Benston, Bromwich and Wagenhofer 2006). In the description, there should be included the economics of the transaction or event in order to provide a common understanding of the economics. Finally, the standard should encompass a clear-cut line between economics of the transactions and the financial statements therein, “using the framework to classification and measurement issues associated with this mapping (Benston, Bromwich and Wagenhofer 2006).

In many forums, the rules-based standards have been termed as being rigid, while, on the other hand, the principle-based standards are just general explanations and definitions of concepts and theories of economics (Kershaw 2005). The rigidity of the rules-based standards is represented by the application of a certain rule that stated, “The annual depreciation expense for all fixed assets is to be calculated as ten percent of the original cost of the asset until the asset is fully depreciated” (Laureen et al. 2003, p.4).

This standard did not leave any space for negotiation or giving a second thought. At this point, the coherence and comparison of firms come in with time (Hronsky and Houghton 2001). This standard lacked consistency because it did not reveal the fundamentals of economics of the ‘reporting time’, which vary and differ from one company to another (Laureen et al. 2003, p.5). This simply means that different assets in different companies are depreciated at different rates, and therefore, their depreciation cannot be calculated in the same manner (Kershaw 2005).

On the other hand, proponents for principle-based approach favor this method since the rule-based one can easily become useless, dysfunctional in an economic environment that changes or when managers develop creative transactions (Kershaw 2005, p.596). Moreover, principle-based approaches do not decrease the earnings and raise the value of financial reports “in so far as the rules increase managers’ ability to structure transactions that meet these rules while violating the intent” (Nelson et al. 2002).

Principle-based approach focuses on highly flexible outcomes and accountability standards for managers to determine functions and processes used in delivery of objectives and services (Nelson et al. 2002). Meanwhile, the rules-based approach seeks for detailed legislation requirements, rules that demand firms to be compliant, as well as complex interpretation, content, and prescriptive application (Kershaw 2005). Rule-based method seeks to address current economic, legal, and social environments in which the accounting standards are framed, therefore, requiring a constant revision of standards in accordance with the continuous change of these factors (Deegan and Unerman 2006).

The advantages of using principle-based approach are summarized into three broad areas:

1. flexibility;
2. scalability; and
3. robustness (Kershaw 2005, p.596; Benston, Bromwich and Wagenhofer 2006).

In the UK, the current preference is to have accounting standards set to be developed by principle-based approach since it offers general requirements for firms to operate. Flexibility is guaranteed through the provision of the outcomes rather than by prescribing specific rules to make use of organizations that can employ the most effective accounting systems to meet their objectives (Nelson et al. 2002). Moreover, by having broad principles, the approach offers accounting standards’ scalability to adapt those rules to meet the needs and formats of any organization (Deegan and Unerman 2006). Consequently, where the principles are well expressed, there is less likely a chance for the standards to be outdated or a need to regululate amendments, making accounting standards robust.

There are specific characteristics of a standard that make it quality to be principle-based. According to SEC, the principle-based standards are the ones that include:

1. a concise statement of a substantive accounting principle, which incorporates accounting objective;
2. some internal inconsistencies or exceptions;
3. an appropriate amount of implementation guideline;
4. bright-line tests; and
5. a coherent conceptual framework (SEC 2003, p.12).

These characteristics are evident in the example of the principle-based accounting standards SFAS 141 for business combination and SFAS 142 for subsequent accounting for intangible assets (SEC 2003, p.24). These accounting standards with few scope exceptions do not have bright-lines but possess modicum of implementation guidelines. These examples present a striking contrast to the rule-based SFAS 133 accounting standard, which has nine exceptions within its scope and includes 800 pages of guidelines on accounting derivatives (SEC 2003, p.23). A critique of SFAS 141 and 142 does not have most of the basic elements of objectives-oriented standards, but the term ‘principle-based’ describes an ideal variant in this case (SEC 2003, p.24). The suggestion made herein is that standards can be principle-based even though they do not have all those characteristics.

Conclusion

Accounting standards are created with the intention to regulate and raise the compliance of financial reporting of organizations. The setting of these standards is by independent accounting firms or by a regulatory body like the government. In the UK, accounting standards are set by ASB, SSAPs, and GAAP, which issue various types of standards. The approach used to set these standards is determined by the government regulation institutions like ASB and GAAP, and by international setters like IFAS. The major methods in accounting setting common to these setters are rule- and principle-based approaches.

Principle-based approach is based on high principles of true and fair view. Accounting standards are said to be principle-based if they meet the following conditions, such as including few exceptions, offering implementation guidelines, being devoid of bright-lines and derived from coherent conceptual framework. Standards are rule-based if they have specifications, numerical thresholds and bright-lines.

References

Arden, J 1997, ‘True and Fair View: A European Perspective,’ European Accounting Review, vol.6 no.4.

Benston, GJ 2006, ‘Fair-Value Accounting: A Cautionary Tale from Enron’, Journal of Accounting and Public Policy.

Benston, GJ, Bromwich, M, and Wagenhofer, A 2006, ‘Principles- Versus Rules-Based Accounting Standards: The FASBs Standard Setting Strategy’, Abacus, Vol.422, pp.165-188.

Deegan, C & Unerman, J 2006, Financial Accounting Theory, McGraw Hill Education, European Edition, UK.

Hronsky, J and Houghton, K 2001, ‘The meaning of a defined accounting concept: Regulatory changes and the effect on auditor decision making’, Accounting, Organizations and Society, pp.123–139.

ICAS, 2006, Principles Not Rules: A question of Judgment. ICAS, Edinburgh.

Kershaw, D 2005, ‘Evading Enron: Taking Principles Too Seriously in Accounting Regulation’, Modern Law Review, vol.68 no.4.

Laureen, AM, Eli, B, Eric, H, Patricia, FD, et al. 2003, ‘Evaluating Concepts-Based vs. Rules-Based Approaches to Standard Setting’, Accounting Horizons, Questia Online Research, vol.17.

Nelson, MW 2002, ‘Behavioral Evidence of the Effects of Principles- and Rules-Based Standards’, Accounting Horizons.

Nelson, MW, Elliot, JA, and Tarpley, RL 2002, ‘Evidence from Auditors’ about Managers’ and Auditors’ Earnings Management Decisions’, The Accounting Review.

Papadopoulo, P 2011, Approaches and Theories to Standard Setting in Accounting, Munich, Viewed 22 March 2012, via GRIN Publishing GmbH.

Schroeder, RG, Clark, MW and Cathey, J 2001, Financial Accounting Theory and Analysis: Text, Readings, and Cases, 7^th edn, Wiley Publications, UK.

SEC, 2003, ‘Study Report Pursuant to Sections 108(d) of the Sarbanes-Oxley Act of 2002’, Securities, and Exchange Committee.

Ward, G 2005, ‘A Matter of Principle’, Internal Auditor, pp.62-66.