Principles-Based versus Rules-Based Accounting Standards
If you were to pose a question to any undergraduate accounting major with familiarity about IFRS as to what is the primary distinction between IFRS and U.S. GAAP, you’d probably get the response that IFRS is principles based and U.S. GAAP is rules based. It’s a notion that was promoted by former IASB Chairman Sir David Tweedie on many occasions, and frequently reported by the popular press to the extent that it’s simply considered a fact by most people. Of course, it’s not that clear cut.
The FASB was the first standard setter to produce a framework for the purpose of establishing principles upon which all standards would be created. Due to political forces and other factors, this effort has not always been successful over the FASB’s lifetime, but it would be unfair to characterize FASB standard-setting as void of principles. Furthermore, principles without rules relative to ad-hoc standards can be equally problematic. A primary reason why we have standards in the first place is to establish common financial reporting practices to facilitate comparisons across companies and over time. Throwing out a principle as a standard without accompanying guidance that establishes some rules is likely to lead to various interpretations that result in inconsistent application. The key is to find just the right amount of guidance to mix with the principles.
This post was prompted by an article in Forbes, whose author has a large audience. The premise of the article is that E&Y is doing something nefarious by providing revenue recognition guidance to start-up companies using new technologies, while simultaneously perhaps providing auditing assurance that the guidance is consistent with U.S. GAAP. While the article’s main point surrounds auditor independence, there is explicit mention that the guidance provided by E&Y is inconsistent with GAAP and furthermore, accounting regulators should be the body that provides the guidance – not experts in the field like E&Y. There is no evidence in the article that the E&Y guidelines are not consistent with GAAP (only implication), but my issue comes back to how much guidance should standard setters provide?
Sir David Tweedie and other very smart people have said that principles based standards are superior to rules based standards because rules present opportunities for financial engineering. As soon as a rule is created, the argument goes, it creates a boundary for financial engineers to work around. As long as the engineers stay within the rules, the auditors/regulators are not capable of requiring something else that is more supportive of the underlying economics. The counter to this is if a manager was determined to get someplace that required sophisticated financial engineering to achieve, wouldn’t it be easier to get there without the rule to work around? And, couldn’t a fuzzy principle be interpreted in many different ways that would result in many different forms of accounting? In fact, isn’t that what we have observed over time? One of the reasons why U.S. GAAP is so dense is because new guidance (i.e., rules) is created to eliminate inconsistent practices that have evolved in practice. Arguments on both sides are more complex than this, but the point is that the appropriate level of guidance to give to a principles-based standard is not an easy determination.
The FASB and IASB are working on their joint revenue recognition standard that is unmistakably principles based. The proposed standard is public knowledge and while it is not yet final, the overarching principle and 5-step model is not likely to change. Yet, there is still a demand in several circumstances for additional guidance, as indicated by Zynga and Facebook in the Forbes article. This demand is completely rational on the part of the preparer as they want to avoid uncertainty. Further, the demand will likely come from investors who desire some boundaries that will guide their analysis of the resulting accounting information and comparisons with other companies. The case creates a dilemma: what are the accounting regulators to do? If they provide more guidance, then the “purists” accuse standard setters of establishing too many rules that create opportunities for earnings management. If they provide less guidance, the vacuum is likely to be filled by others, and standard setters are accused of not doing their jobs.
Perhaps the content of this post can generate a nice classroom discussion.