Rules-Based Versus Principle-Based Accounting

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Introduction

Many scandals have occurred in companies based in the U.S originating from employment accounting practices. Companies have often taken advantage of capricious regulations to cunningly configure business transactions producing favourable and untruthful accounting reports. The main reasons are to evade taxation and impress financiers in order to access credit.

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The need to ensure accuracy in reporting and comparability of financial reports in time and across entities is important. Debate in the recent past has been on the two accounting practices and their ability to address emerging controversies in accounting. They are the Rule Based Accounting and the Principle based accounting.

Rule based accounting involves the use of specific conditions laid down in law and other authorities to record, structure and report all business transactions. The full details of how the accounting procedure should be conducted are fully explained (Shortridge & Mark 2009 ¶4).

Principle-based accounting on the other hand is generally an overriding conceptual framework on which accountants base their decisions during practice. Principles are guidelines to be followed in accounting. An example is the “matching Principle”. The principle states that all revenues should be matched with the expenses incurred to earn them. This prevents a case where company records revenue in one period and related expenses in a later period as this inflates the revenues in the earlier period (Berkowitz &Richard, 2002 ¶6).

Principles are broad guidelines which have been viewed as being applicable to numerous situations. They avoid loopholes associated with exact requirements. This has avoided several cases where contents of transactions are altered to fit to certain intentions in the pretext that the laid down rules have been followed. An example is in the accounting for leases. A study by the Financial Accounting Standards Board(FASB) done in 1981 showed that managers purposely structured leases as operating leases to avoid some tax liabilities. This was presented by the use of specific rules which could be cleverly interpreted by accountants (Ronald, Matthew, & Ryan, 2009, ¶2-5).

Rules based accounting does not allow accountants to professionally judge transactions, they simply adhere to detailed rules. Principle based accounting on the other hand gives some leeway for accountants faced with a transaction to establish the best possible way of posting in the books of accounts.

The use of principles instead of rules presents some fundamental weaknesses in accounting. The freedom to subjectively interpret and treat transactions can lead to a range of views on a single transaction. The principle of prudence states that revenues should be recorded only when certain and provisions for expenses should be made when the expense is probable. In this case, interpretation can be varied. Revenue considered being certain may fail to materialise while expenses considered probable may not be incurred. This can present significant inaccuracies in the accounting practice. It is indeed an avenue for crafty accountants to exploit.

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International Accounting Standards (IAS)

The International Accounting Standards (IAS) incorporates sets of rules developed by the International Accounting Standards Board in a bid to harmonise accounting practices internationally. They are about 41 accounting standards as well as 8 financial reporting standards. They are comprehensive rules set out to guide the treatment of specific transactions so as to enhance international comparisons of business entities. Many nations have approved their use parallel to local regulations.

In the US, Generally Acceptable Accounting Practices (GAAP) is in use for local companies. They are a set of guidelines covering areas of accounting such classification of items in the balance sheet and measurements of outstanding shares (Generally Accepted Accounting Principles in the United States, n.d, ¶4).

Enron and WorldCom Scandals

Some serious scandals have in the past occurred in the US and fingers pointed to the general principles.

In the year 2002, Enron and WorldCom were exposed as business run by fraudsters. They had exploited the loopholes in the US GAAP to fraudulently gain wealth. The companies were small in mid 1980’s. The directors of the two companies desired to boost the share values. They only had to exploit loopholes in the GAAPS and develop financial reports that depicted the good health of the companies. With time the share value was rising as investors were duped. They colluded with banks to inflate the incomes using overseas accounts where the banks could stack money and allow the firms to account for the money as their revenues. This prompted people to buy in to the shares as lenders also lent to the firms freely. Later auditors detected the scams leading to bankruptcy (BBCNews, 2004, ¶1-6).

In the year 2001 Enron announced an overstatement in profits of $586 over a period of five years. Its equity per share plummeted to 30 US cents from $85. It was later sued for over $320 million owed to former employees (Arnold, n.d, ¶3).

In 2002 WorldCom had to restate its financial statements for 2001. It was found to have capitalized costs to $797 million from $540 million. In late 2003 its assets were inflated by a whooping 12 Billion (Arnold, n.d, ¶5)

The scams were well crafted to exploit the loopholes in the principles over time. This was a big lesson on the weaknesses of the principles. It dawned to the authorities that clear set out rules could be more effective in preventing such scams. The debate on effectiveness of the GAAPs was sparked. The international standards are visibly more elaborate and less likely to lead to such scams.

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In the year 2007, the Securities Exchange Commission (SEC) allowed international firms cross listing in the US to use IAS. The main driving force was that, the SEC realized that the IAS were also highly accurate and in fact, the firms applying US GAAP generally had higher value relevance in accounting amounts than foreign firms applying IAS. This was proof that the IAS lead to more prudent reporting than the US GAAP

Indeed Floyd (2008) observed a movement by the US towards the adoption of the IAS in place of the US GAAP. The SEC allowed some large American companies to use IAS in reporting in the starting from the year 2009. The commission actually set a deadline for the full adoption of the IAS by American Companies by the year 2016 (¶2-4).

Conclusion

These are bold steps taken by the SEC as a result of the confidence they have in the IAS in preparation of the financial. However, it should always be taken to account that new challenges will emerge even with the IAS. Accountants can purport to stick to the set out rules in interpreting transactions and in the process mislead in reporting. Therefore for effective use of the rule-based accounting, the authorities developing the rule have to be very pro-active. This will minimize cases where accountants are faced with unclear circumstances hence improve the truthfulness and fairness of financial reports.

Reference List

Arnold I. (n.d). Enron/WorldCom Parmalat. Web.

BBCNews. (2004).The banks that robbed the world. Web.

Berkowitz, A., & Richard R. (2002). The Accounting Debate: Principles vs. Rules. Art Berkowitz Seminars. Web.

Floyd N. (2008). U.S. Moves Toward International Accounting Rules. Web.

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Generally Accepted Accounting Principles in the United States (2009). Web.

Ronald, M., Matthew, M. & Ryan, P. (2009) Principles-Based Accounting CPA JOURNAL. Web.

Shortridge, R., & Myring, M. (2009). Defining Principles-Based Accounting Standards CPA JOURNAL. Web.

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