Principles Based Accounting Standards
(Chapter 9)
The attempted move toward principles-based accounting standards is most likely rooted
in the move toward convergence between FASB standards and IASB standards, although the role
of other nations in the G4+1 (United Kingdom, Canada, Australia, and New Zealand) should not
be discounted. However, of more immediate importance is that the Sarbanes-Oxley bill required
the SEC to draft a report on principles-based accounting standards that would better align the
interests of management and auditors with investors. We will define principles-based standards
as those rooted in economically relevant criteria which provide a high degree of comparability
among firms and are useful in terms of either predicting future cash flows or evaluating firm
performance. Notice the relationship of principles-based standards to finite and rigid uniformity
(Chapter 9) and the conceptual framework (Chapter 7).
The most complete statement about principles based standards appeared in the recent
SEC report (hereinafter “the report”).1 The report mentions three different types of standards.
The first is a principles-only approach in which limited guidance is given for applying the
standard. Examples mentioned in the report are impairment of long-lived assets prior to SFAS
No. 121 and historical cost depreciation. Impairment does not provide a good example because
no extant ARB, APBO, or FASB standard explicitly or even implicitly covers this topic hence no
guideline can exist absent an applicable rule or even a well formulated “principle” stemming
from accounting practice. Historical cost depreciation provides a better example of a principlesonly standard. Paragraph 5 of Chapter 9 of ARB 43 mentions the now famous “systematic and
rational” description of historical cost depreciation but no further guidance is provided.
Of more importance is the rules-based approach to standard setting. Rules-based
standards often provide “bright-lines” tests which can easily be avoided. As a result,
representational faithfulness may be avoided and a low degree of comparability will often result.
Numerous exceptions may also result. The classic example of a rule-based standard is provided
by lease accounting (Chapter 16). However, a G4+1 report on lease accounting (pp. 603-605)
would transform lease accounting into a true principles-based standard.
The report uses the term objectives-oriented standards for a true principles-based
approach. Objectives-oriented standards, according to the report, would not use bright-line tests
and would have very few exceptions.2 They would also provide adequate guidelines for
implementation but they would still require the use of judgment by accountants and auditors.
Standards can never cover every possible situation and contingency so judgment would be
needed to best capture the underlying economic reality. There is thus a gray area between
US Securities and Exchange Commission (2003): “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of
2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting
System.”
2
Schipper states that most standards drafted by the FASB are principles-based. However, the number of scope and
treatment exemptions makes them ‘appear’ to be rule-based. See Katherine Schipper, “Principles-Based
Accounting Standards,” Accounting Horizons, March 2003, pp. 61-72.
1
providing enough detail to allow a standard to be operationalized on the one hand as opposed to
providing sufficient information to cover virtually every contingency. Before the line of too
much detail is crossed, judgment would come into play. Finding this happy medium will not be
easy. In addition, when judgment comes into play we enter the arena of potential moral
turpitude, a situation that we accountants have become much too familiar with of late.
The objectives-oriented aspect of principles-based standards would require a clearer
delineation in the conceptual framework in terms of how to determine trade-offs between
relevance and reliability (Chapter 7) and how these would impact comparability.
Still further changes and improvements would need to be made to the conceptual
framework. As discussed in Chapter 7, SFAC No. 5 takes a very “status quo” approach to
measurement and recognition criteria with the revenue-expense approach being an acceptable
part of the mix. This is in conflict with SFAC No. 6 where the definition of elements is oriented
toward the asset-liability view. If SFAC No. 5 can be made consistent with SFAC No. 6, the
way should be paved toward a more orderly and consistent move toward more appropriate
measurement attributes for assets, liabilities, revenues, and expenses, although we can expect
some applications of historical cost to be with us for a considerable time to come.
In addition to these conceptual framework clarifications mentioned in the report, further
examination toward principles-based accounting might stem from possible conflicts between the
user objectives of predicting future cash flows as opposed to evaluating entity (and management
performance. SFAC No. 2 opts in favor of predicting future cash flows as the primary user
objective. In the case of pension accounting (SFAS No. 87) a conflict is present between these
two objectives (Chapters 7 and 15) which also involves issues such as the definition of a liability
and trade-offs between relevance and reliability as well as — ultimately — comparability.
Hence it is highly possible that resolving conflicts between relevance and reliability could
involve the overriding user objectives.
The report cites SFAS Nos. 141 and 142 as examples of principles-based accounting
standards. SFAS No. 141 eliminates pooling of interests, a step long overdue (see Chapter 17).
SFAS No. 142 eliminates formulaic write-downs of goodwill with provisions for testing for
possible impairment. Among other standards mentioned as good examples of principles-based
standards in SFAS No. 52 on foreign currency translation. Our analysis of this standard in
Chapter 18 sees SFAS No. 52 as a good application of finite uniformity.3
We believe that the report provides a good road map for implementing principles-based
accounting standards. The fact that it is an SEC report, as opposed to an academic study, or even
a FASB or IASC report, bodes well for a speedier implementation.
US Securities and Exchange Commission (2003): “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of
2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting
System.”
Schipper states that most standards drafted by the FASB are principles-based. However, the number of scope and
3
For the conversion of SFAS No. 87 on pensions to a principles-based standard see AAA Financial Accounting
Standards Committee, “Evaluating Concepts-Based vs. Rules-Based Approaches to Standard Setting, Accounting
Horizons, March 2003, pp. 73-89.
treatment exemptions makes them ‘appear’ to be rule-based. See Katherine Schipper, “Principles-Based
Accounting Standards,” Accounting Horizons, March 2003, pp. 61-72.
For the conversion of SFAS No. 87 on pensions to a principles-based standard see AAA Financial Accounting
Standards Committee, “Evaluating Concepts-Based vs. Rules-Based Approaches to Standard Setting, Accounting
Horizons, March 2003, pp. 73-89.