Principal vs Rule Based Accounting

An Insight on IFRS versus U. S GAAP & Implications of IFRS adoption on Financial Statement and Accounting Quality Q2) Principle and rule-based accounting reflect different approaches to accounting. The pros and cons of rule-based accounting (RBA) and principle-based accounting (PBA) are as discussed. (1) RBA deters creative accounting as rules reduce opportunistic discretion unlike PBA which is more subjective and ambiguous. On the other hand, others argue that rules are a means to circumvent the objectives of a standard and more vulnerable to transaction restructuring.

Principles leave less room for preparers to justify “inappropriate” interpretations of standards, thereby reducing creative accounting. (2) The complicated accounting rules used under RBA is too onerous, creating problems for users, preparers and setters alike. In seeking compliance with rules, users tend to lose focus on the spirit of the standard and objectives of fair presentation. Principles are simpler, focused on objectives and hence user-friendly to the masses. (3) It is said that rules provide greater comparability due to application of consistent rules on events and transactions.

Furthermore, Sunder’s article argues that IFRS’s principle-based approach introduces more judgement, “giving rise to greater variability in application than a more detailed rule”. However, comparability can be enhanced under PBA if more disclosures are made on key judgements made. (4) Due to its authoritative and prescriptive nature, rule-based standards lower ambiguity and hence, tend to lower litigation risks for auditors and preparers. PBA involves greater judgement and discretion, hence increasing their exposure to litigation risk. Increased documentation may mitigate such risks though. 5) RBA is desired by preparers and auditors as it provides detailed guidance and ‘black-and-white’ solutions to ambiguous issues. This results in deterioration of quality of the accounting profession. Conversely, PBA requires professionals to exercise judgement and take personal responsibility. This promotes cultivation of skilled professionals essential to the development of the accounting industry. (6) RBA standards are not comprehensive as no amount of rules can detail all possible scenarios. Furthermore, it is static relative to industry changes. In contrast, PBA is comprehensive and flexible enough to handle new problems in this dynamic nvironment. Q3) Overarching importance is placed on the decision usefulness of financial statements, as stated by the objectives of reporting standards. Decision usefulness in turn is determined by the qualitative characteristics of relevance and reliability. Relevance is defined as “information capable of making a difference in users’ decisions. It must be noted that information relevant for decision-making differs amongst stakeholders. Firm owners may require information for stewardship purposes whilst investors may want information predicting a firm’s future cashflows for valuation purposes.

This results in stakeholders having different preferences for types of measurement and accounting standards, which the IFRS may or may not fulfil. However, in light that financial statements are designed mainly to meet the needs of external users not privy to internal information, i. e. the investors and creditors mainly, relevance has generally been elevated with the use of IFRS. For e. g. IFRS has seen improvements in aspects like off-balance sheet items, segment reporting and consolidation. Cash items are more visible as compared to the past and there is greater balance sheet transparency as desired by investors.

This is in line with the trend of the marketing moving towards use of current value computations relative to less savvy value measures such as P/E ratios. IFRS has resulted in greater disclosures being made and hence much more information being included in the financial statements today, in particular, the notes to financial statements. However, there is still room for progress, such as rules on capitalisation of R&D outlays. Reliability is defined as information that is free from material error and bias and can be depended on by users to represent faithfully either that which it purports or could reasonably be purported to represent.

Reliability has been replaced with ‘faithful representation’ which has the added element of applying to “the real world economic phenomena” and added qualities of being verifiable, neutral and complete. As the IFRS utilises a principle-based approach, more judgements and discretion are introduced into financial reporting. In addition, IFRS is said to employ more fair value accounting than other standards (Whittington, 2006), such as US GAAP (use of historical cost) and IFRS 16 (revaluation of PPE allowed). All these are said to trade off reliability for relevance.

However, reliability may not always be compromised and relevance and reliability are not always mutually exclusive. It depends on the financial element, standard and measurement applied. For e. g. financial assets with active markets using fair value accounting are both reliable and relevant. In contrast, the mark-to-judgement model is heavily dependent on estimations and lacks the quality of verifiability. In conclusion, the decision usefulness of financial statements is improved due to greater relevance and better reflection of economic reality despite possible trade-offs in reliability.

Q4) For this question, I focus on whether accounting quality and firm valuation is improved in the context of U. S. which will lend context to my argument as follows. Adopting the IFRS will lead to increased comparability and transparencies of financial statements issued by different firms around the world due to increased consistency in application of common accounting standards. This increases understandability for users and reduces their cost in interpreting financial statements, thereby enabling users to better estimate firm values.

Secondly, adopting IFRS not just means a reduction of accounting costs incurred, but also more effective global disclosures for firms, especially international firms as it is now easier to coordinate accounting treatments and efforts across global units. More and improved disclosures translate to more information for investors, lower estimation risks and hence better valuations for investors. Thirdly, IFRS is a principle-based standard. Relative to the rule-based GAAP, a principle-based standard like IFRS has more advantages as explained by Q1 above.

Generally, principle-based standards is more comprehensive, flexible and most importantly, better reflects economic reality, hence enhancing accounting quality. Furthermore, corresponding to Q2, IFRS also increases relevance and hence decision usefulness of financial statements, despite trade-off in reliability under certain circumstances. Hence adoption of IFRS in U. S. will generally improve accounting quality and firm valuation. Fourthly, from the article, ‘IFRS and Accountants’ Liability’, IFRS’s emphasis on judgement increases litigation exposure for management and auditors.

Management is responsible for their own judgements and discretion, hence they will exercise greater caution and efforts in understanding the economic substance of transactions to avoid potential liability in case of error. This is similar for auditors who will assess management judgement more carefully now. An increase in preparation efforts by firms and reviewing efforts by auditors will thus increase accounting quality and valuation. Fifth, adoption of a principle-based IFRS that requires greater judgement will generally improve the quality of the accounting profession.

Rule-based standards result in rote-learning while principle-based accounting develops judgement, powers of abstraction and critical thinking. An increase in skilled accounting professionals as preparers and auditors will thus improve accounting quality. Opponents argue that each country has its own social norms, economic systems and diversities. Hence, IFRS will not be able to accommodate such differences in local conditions. However, IFRS is based on accounting practices of English-speaking countries. In the context of U. S. differences in local conditions and accounting practices between the English-speaking countries and U. S. are not as stark as compared to, say, China. Moreover, IFRS and U. S GAAP are largely similar with the main difference lying in the principle- versus rules-based approach and details of implementation and guidance. The transition of U. S to adopt IFRS is thus not as difficult and financial reporting should be able to accommodate these local conditions. Granted, it may be argued that local conditions are still different amongst English-speaking countries.

However, this can be overcome as long as standard-setters allow enough breadth in the interpretation of principles to enable such economic reality to surface (ICAS, 2006). In conclusion, adoption of IFRS will improve accounting quality and valuation due to increased comparability, disclosures and quality of financial statements prepared whilst the main drawback of IFRS’s inability to accommodate local conditions can be overcome by broadening the standard’s scope of interpretation and flexibility of a principle-based standard. References 1. Sunder, S. (2009).

IFRS and the Accounting Consensus. Accounting Horizons 2009, Vol. 23 (1) pp. 101-111 2. Scannell, K. Slater, J. (2008) SEC Moves To Pull Plug On U. S. Accounting Standards. The Wall Street Journal 3. Crovitz, L. (2008). Information Age: Closing the Information GAAP. The Wall Street Journal 4. Boschat, N. (2008) IFRS Spells ‘Write-Downs’. The Wall Street Journal 5. Henry, D. (2008) A Better Way To Keep The Books? The U. S. wants to adopt simpler accounting rules used by other countries. But there could be problems. Business Week 6. Love, V. J. Eickemeyer, J. H. (2009).

IFRS and Accountants’ Liability. The CPA Journal, 79(4). 7. IAS Plus. (2008). IFRS & US GAAP: A pocket comparison. Retrieved www. iasplus. com/dttpubs/0809ifrsusgaap. pdf 8. Schipper, K. 2003. Principles-based accounting standards. Accounting Horizons 17: 61–72. 9. Webster, E. , and D. B. Thornton. 2004. Earnings quality under rules- vs. principles-based accounting standards: A test of the Skinner hypothesis. Working paper, Queen’s University. 10. Kroeker. J. L. Remarks before the 2007 Conference on Principles-Based Accounting and the Challenges of Implementation.

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