Defining Principles-Based Accounting Standards
By Rebecca Toppe Shortridge and Mark Myring
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A key concern arising from the recent business scandals is that U.S. accounting standards
have become “rules-based,” filled with specific details in an attempt to address as many
potential contingencies as possible. This has made standards longer and more complex,
and has led to arbitrary criteria for accounting treatments that allow companies to
structure transactions to circumvent unfavorable reporting. In addition, the quest for
bright-line accounting rules has shifted the goal of professional judgment from
consideration of the best accounting treatment to concern for parsing the letter of the rule.
To address these concerns, the Sarbanes-Oxley Act of 2002 required the SEC to examine
the feasibility of a principles-based accounting system. The SEC rendered an interesting
study that focuses on “objective-oriented” standards (www.sec.gov/news/studies.shtml).
Accounting firm leaders have supported a move toward principles-based standards. Sam
DiPiazza, CEO of PricewaterhouseCoopers, and Ed Nusbaum, CEO of Grant Thornton,
have both publicly proposed a switch to principles-based standards. The Financial
Accounting Standards Committee (FASC) of the American Accounting Association
believes that a principles-based approach is more likely to result in transactions that
reflect their true economic substance. Finally, FASB Chair Robert Herz has said that the
current rules-based system is problematic because “those who want to comply with rules
... are not always sure of everything they need to look at. Those looking to get around the
rule … can use legalistic approaches to try and do it” (Business Week online, 2002).
Despite all of this discussion, a precise definition of principles-based accounting remains
elusive. What follows is a proposed definition and an explanation of how standards
developed according to this definition would differ from the current system. The
usefulness of the definition is demonstrated by a comparison of U.S. Generally Accepted
Accounting Principles (GAAP) and International Accounting Standards (IAS) regarding
the treatment of leases. Principles-based accounting has advantages and disadvantages,
which should be weighed in the context of FASB-proposed movement toward principlesbased accounting.
Principles-Based versus Rules-Based Accounting
Simply stated, principles-based accounting provides a conceptual basis for accountants to
follow instead of a list of detailed rules.
In a 2002 presentation to the Financial Executives International, Robert Herz, Chairman
of FASB, explained it as follows:
Under a principles-based approach, one starts with laying out the key objectives of good
reporting in the subject area and then provides guidance explaining the objective and
relating it to some common examples. While rules are sometimes unavoidable, the intent
is not to try to provide specific guidance or rules for every possible situation. Rather, if in
doubt, the reader is directed back to the principles.
GAAP is a principles-based system—at least when standards are initially contemplated.
Essentially, the Statements of Financial Accounting Concepts provide a roadmap to
establishing standards. The problem arises when specific standards come up for
consideration.
FASB member Katherine Schipper has explained that one of the overriding financial
accounting concepts is the usefulness of accounting information to decision makers. This
implies that the information should be relevant, reliable, and comparable across reporting
periods and entities. If the only requirements were that information be relevant and
reliable, entities would adopt reporting methods to best reflect the economic realities for
their particular entity. But this would make comparison between companies and across
reporting periods virtually impossible for investors.
The problem arises when standards setters approach the difficult task of determining the
appropriate level of detailed guidance to achieve sufficient comparability and consistency
in financial statements. A principles-based standard often becomes a rules-based standard
in an effort to increase comparability and consistency. An example of this process is
demonstrated by SFAS 133, Accounting for Derivative and Hedging Activities, which
requires that all financial instruments be measured at fair value. A fundamental question
addressed in this standard is the definition of a derivative. SFAS 133 provides three
paragraphs to define a derivative. FASB received so many questions about the definition
that the Derivatives Implementation Group has issued at least 22 statements to provide
additional clarification. A further question is how to measure the fair value of an
identified derivative. If no guidance is provided on this issue, numerous measures of fair
value are potentially justifiable: the asking price, the bid price, or the average of the bid
and ask prices. Thus, a rule was added to delineate exactly how fair value should be
determined. Thus, a principle requiring financial instruments to be measured at fair value
became a detailed rule with complex stipulations and exceptions that allow corporations
to structure contracts to achieve favorable reporting.
Lease Accounting Under Rules-Based and Principles-Based Approaches
The International Accounting Standards Board (IASB) has primarily followed a
principles-based approach to standards setting. Thus, their standards provide a
comparison to FASB’s approach. Principles-based accounting for leases is addressed in
six IASB pronouncements and one interpretation. In contrast, U.S. GAAP related to lease
accounting is addressed in 20 Statements, nine FASB Interpretations, 10 Technical
Bulletins, and 39 EITF Abstracts. The depth of GAAP coverage of leases is characteristic
of the rules-based accounting system in the U.S.
Accounting for leases is primarily addressed in International Accounting Standard 17
(IAS 17). This standard provides broad guidance on classifying lease contracts as capital
or operating. (The Exhibit shows the criteria used to differentiate between capital and
operating leases.) The principles-based IAS 17 states simply that a lease “is classified as
a finance (i.e., capital) lease if it transfers substantially all of the risks and rewards
incident to ownership” to the lessee. IAS 17 does not provide an opportunity to write
contracts that avoid minimum requirements. If the substance of the lease is capital, the
property must be recorded as an asset and liability on the lessee’s books. In essence,
under IAS 17 it is difficult for companies to write lease contracts that allow off–balancesheet financing.
SFAS 13, the primary standard for lease accounting in U.S. GAAP, is an example of a
rules-based standard. SFAS 13 was enacted in an attempt to force corporations to
recognize the substance over the form of a leasing agreement. Specifically, during the
1980s, many companies began using leasing arrangements as a means of off–balancesheet financing. In some instances, companies would buy a piece of equipment, sell it to
another entity, and then lease it back to avoid recording an asset and a liability for the
equipment. SFAS 13 requires that firms distinguish between operating and capital leases
using four specific criteria, whose purpose is to ensure that leases that are essentially
purchases be treated as such (see the Exhibit). If a contract satisfies any of the four
criteria, it must be recognized as a capital lease in the financial statements. FASB hoped
that by providing explicit rules, individual judgment would be eliminated and the
standards would be consistently applied. In many respects, this strategy backfired.
Because precise rules were established, companies carefully structured lease contracts to
qualify as operating leases. As a result, the explicit rule allows the off–balance-sheet
financing to continue, and provides justification for the treatment.
Advantages and Disadvantages of Principles-Based Accounting
What are the advantages and disadvantages of principles-based accounting? Perhaps the
primary benefit of principles-based accounting rests in its broad guidelines that can be
applied to numerous situations. Broad principles avoid the pitfalls associated with precise
requirements that allow contracts to be written specifically to manipulate their intent. A
1981 study sponsored by FASB found evidence that managers purposefully try to
structure leases as operating leases to avoid incurring additional liabilities. Providing
broad guidelines may improve the representational faithfulness of financial statements.
In addition, principles-based accounting standards allow accountants to apply
professional judgment in assessing the substance of a transaction. This approach is
substantially different from the underlying “box-ticking” approach common in rulesbased accounting standards. FASB Chair Robert Herz has stated that he believes the
professionalism of financial statements would be enhanced if accountants are required to
utilize their judgment instead of relying on detailed rules.
Another advantage of a principles-based system is that it would result in simpler
standards. Herz has claimed that a principles-based system would lead to standards that
would be less than 12 pages long, instead of over 100 pages (BusinessWeek online,
2002). Principles would be easier to comprehend and apply 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.”
Finally, the use of principles-based accounting standards may provide accounting
statements that more accurately reflect a company’s actual performance because, as
Australian Securities and Investments Commission Chair David Knott has stated, an
increase in principles-based accounting standards would reduce manipulations of the
rules (Nationwide News, 2002).
Conversely, there are potential drawbacks to a principles-based approach to standards
setting. A lack of precise guidelines could create inconsistencies in the application of
standards across organizations. For example, companies are required to recognize both an
expense and a liability for a contingent liability that is probable and estimable. On the
other hand, a contingent liability that is reasonably possible is only reported in the
footnotes. With no precise guidelines, how should companies determine if liabilities are
probable or only reasonably possible? The lack of bright-light standards may reduce
comparability and consistency, a primary precept of financial accounting.
Many accountants seem to prefer rules-based standards, possibly because of their
concerns about the potential of litigation over their exercise of judgment in the absence of
bright-line rules. The number of requests for implementation guidance received by FASB
has always been high, and their significance resulted in the formation of the Emerging
Issues Task Force. If financial statements conform with accepted rules, the bases for a
lawsuit are diminished.
Future of Principles-Based Accounting
In October 2002, FASB issued a proposal concerning a principles-based approach to
standards setting. The proposal discusses the objectives of financial accounting and how
a principles-based approach would help to accomplish those objectives. It also provides
an outline for the conversion to a principles-based approach, which entails three
priorities.
First, the current conceptual framework, which provides guidance for standards, has been
characterized by FASB as “incomplete, internally inconsistent, and ambiguous.” For
example, while FASB’s Concept Statement 2 discusses the qualities of relevance and
reliability, it does not provide any guidance for trading one for the other. In addition, the
revenue recognition principles contained in Concept Statement 5 are frequently
inconsistent with the definitions of assets and liabilities in Concept Statement 6 (FASB
2002). Because of the current shortcomings of the conceptual framework, the first step in
establishing a principles-based system is to improve the accounting concepts and develop
an overall reporting framework.
Second, the number of exceptions contained in the standards must be reduced. Much of
the current detail in standards arises from three kinds of exceptions: scope, transition, and
application. Scope exceptions allow the use of prior standards to continue when a new
standard is adopted. Transition exceptions reduce the effects of changing to a new
standard. Application exceptions are granted to obtain a desired accounting result. For
example, to reduce the volatility of pension expenses, estimated returns on plan assets are
utilized instead of actual returns. While scope and transition exceptions would still occur,
FASB has proposed eliminating application exceptions in a principles-based system. The
reduction in exceptions would greatly reduce the details and complexity of standards and
more clearly reflect the economic events of an entity.
Finally, much of the interpretive and implementation guidance to standards would be
eliminated in the move to a principles-based approach. This change poses difficulties;
FASB has received an increasing number of requests for implementation guidance from
its constituents. The intention of interpretive and implementation guidance is to increase
comparability between reporting entities. However, in recent years the amount of
guidance has increased substantially. Thus, FASB must decide what guidance is
appropriate and how much guidance is too much.
In a 2002 interview with Business Week, Herz indicated that a change to principles-based
standards would be gradual. Instead of starting all over, any new standards would follow
the principles-based method but existing standards would not currently be replaced.
FASB’s goal would be a smooth transition rather than an abrupt switch in accounting
standards.
Implementation of a principles-based approach to standards setting will not be easy,
however. It will require a fundamental shift in attitude from all constituents of financial
accounting information, including standards setters, the SEC, investors, preparers,
auditors, and the public.
Rebecca Toppe Shortridge, PhD, CPA, and Mark Myring, PhD, are both assistant
professors in the department of accounting at the Miller College of Business, Ball State
University, Muncie, Ind