Critical Review of Principles-Based Accounting Standards Essay

Introduction Schipper (2003) who is a member of FASB conducted a study on the rules-based and principles-based accounting standards. The aim of this article is to discuss the attributes and potential effects of transferring from rules-based standards to principles-based standards. To some extent this article is critical, but several limitations need to be discussed, such as implementation guidance. Summary Schipper (2003) demonstrated that there was a long-running debate on whether U. S. GAAP should be shifted to principles-based system instead of rules-based system.

To measure its applicability, SEC and FASB had conducted a study and developed a proposal respectively. Schipper (2003) argued that U. S. GAAP was based on principles guided by FASB Conceptual Framework. He used examples to explain how U. S. GAAP achieved relevance, reliability and comparability. In addition, Schipper (2003) illustrated why a recognisable principle became complex and detailed by giving instances. In situations, a recognisable principle needs additional guidance and explanation to support. Schipper (2003) showed that scope exceptions, treatment exceptions and detailed implementation guidance made U.

S. GAAP appeared to be rules-based standards and stressed on implementation guidance. Furthermore, Schipper (2003) discussed potential consequences of adopting principles-based standards. Generally, Schipper (2003) held the point that shifting U. S. GAAP to principles-based standards and abandoning rules-based standards were not appropriate. Critique Some key points stated were highly reasonable. Schipper (2003) mentioned that detailed implementation guidance could increase comparability as it reduced the effects of differences in professional judgment.

Principles-based standards have insufficient guidance, which need accountants and auditors to apply professional judgments and may lead to variable decisions cross periods and entities. Shortridge & Myring (2004) claimed that principles-based standards would make investors cannot compare between companies and make across reporting periods impossible. Agoglia, Doupnik, & Tsakumis (2011) also demonstrated that increased judgment of principles-based standards could lead to a decrease in comparability across firms (e. g. IBM, Pfizer, Goldman Sachs, and BDO Seidman).

Meanwhile, Schipper (2003) discussed that detailed implementation guidance could reduce difficulties of enforcement and incidence of litigation. Before enforcing principles-based standards to companies, the most important and difficult thing is to decide the additional level of detailed guidance. Cheney (2004) showed that FASB struggled with how much specific guidance to offer in explanation to the principles behind a given standard. As for litigation, because a lack of detailed guidance, principles-based standards may make auditors drop into a litigation with clients.

Ng (2004) also explained that auditors wanted specific rules that provide guidance to protect themselves in litigation. However, Schipper (2003) primarily emphasised the significance of rules-based standards and the potential effect of principles-based standards, but ignored the limitations of rule-based standards. On the one hand, Schipper (2003) stated that rules-based standards could reflect relevant, reliability and comparability, but they may ignore economic reality of transactions. As to be known, Enron fraud in 2002, they pretended to increase their annual profit by overstating income and concealing expenses in financial statements.

However, having a quickly looking at their financial statements, they seemed to comply with U. S. GAAP. The main reasons for their fraud may be their complex transactions and limitation of rules-based standards system. Cheney (2004) stated that Enron fraud resulted from a company justifies financial reporting by using bright lines of specific guidance. Dickey & Scanlon (2006) explained that highly complex transactions may have conformed to technical U. S. GAAP rules, but did not reflect economic reality.

Meanwhile, Klein (2003) indicated that rules-based standards allow loopholes for those who want to engineer their way around the standard intent. These may imply that rules-based standards just require information to be relevant, reliable and comparability, but ignore to reflect economic substances. While principles-based standards are simpler with a reduction of complexity, it may make the financial statements more transparency. For this point, Kivi, Smith & Wagner (2004) showed that Enron debacle demonstrated the need for a principles-based definition of control.

At the same time, Agoglia, Doupnik & Tsakumis (2011) made a research about the effect of principles-based standards and rules-based standards on aggressive reporting and they found that preparers were less likely to report aggressively when applying a principles-based financial reporting standard. Therefore, principles-based standards may reduce misleading financial statements to some extent. In contrast, Schipper (2003) explained many positive effects of implementation guidance, but did not mention negative effects such as complication.

For lease accounting, Shortridge & Myring (2004) made a summary that principles-based accounting for lease was addressed in 6 IASB pronouncements and one interpretation, but U. S. GAAP related to lease accounting was addressed in 20 statements, 9 FASB interpretations, 10 technical bulletins, and 39 EITF abstracts. The length of lease accounting gives rise to complexity. Reither (1998) also made a survey and the results showed that the standard for lease accounting under U. S. GAAP (SFAS NO. 13) had been identified to be the worst accounting standard.

Recommendation and Conclusion In order to make the article more completed, some other points should be put forward. Exactly as Schipper (2003) discussed, principles-based standards might include rules elements which could make them appear to be rules-based standards. This implies that principles-based standards may be mixed with rules-based standards, only transferring to pure standards may be not appropriate. Heffes (2003) explained that there was no a pure rules- or principles-based regulatory system.

Meanwhile, different users may like different types of standards. Miller & Bahnson (2010) stated that educators, students and preparers like principles-based standards, but auditors and regulators like rules-based standards. Philips, Drake & Luehlfing (2010) also made a research which indicated that corporate managers prefer principles-based standards, while creditors and investors like rules-based standards and they believed that new standards will probably combine rules-based with principles-based characteristics.

Furthermore, SEC made a result of objective-oriented standards through their study. Miller & Bahnson (2010) emphasised that the rules would follow from and work toward broader reporting objectives. So it is to be recommended author to discuss something about objective-oriented standards. In conclusion, this article is highly critical and logical in majority, but still has some limitation when analysed rules-based standards and has a lack of talking about objective-oriented standards. Reference Agoglia, C. P. , Doupnik, T. S. amp; Tsakumis, G. T. (2011) Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions, The Accounting Review, 86 (3), pp. 747-767. Cheney, G. (2004) FASB struggles with the line between principles & rules, Accounting Today, 8 (21), pp. 5-40. Dickey, J. C. & Scanlon, M. J. (2006) Securities Accounting, Insights, 20 (2), pp 13-18. Heffes, E. M. (2004) Principles-Based or Rules-Based Standards, Financial Executive, 20 (8), pp. 8-19. Klein, M. (2003) SEC weighs in for principles, Accounting Today, 17 (15), pp 1-46. Kivi, L. , Smith, P. & Wagner, C. (2004) Principles-Based Standards and the Determination of Control for Consolidation, The CAP Journal, 74 (5), pp. 11-13. Miller, P. B. W. & Bahnson, P. (2010) It’s principles and rules, not principles or rules, Accounting Today, 24 (1), pp. 12-13. Ng, M. (2004) The future of Standards Setting, The CPA Journal, 74 (1), pp. 18-20. Phillips, T. J. , Drake, A. D. ;amp; Luehlfing M. S. 2010) Transparency in Financial Reporting: a look at rules-based versus principles-based standards, Academy of Accounting and Financial Studies Journal, 14 (4), pp. 11-28. Reither, C. L. (1998) What are the Best and the Worst Accounting Standards? Accounting Horizons. 12 (3), pp. 283-292. Schipper, K. (2003) Commentary Principles-Based Accounting Standards, Accounting Horizons, 17 (1), pp. 61-72. Shortridge, R. T. ;amp; Myring M. (2004) Defining Principles-based Accounting Standards, The CPA Journal, 74 (8), pp. 34-37.