Hi, Please help me make this weekly discussion, I’ve posted a sample of a response as a guide or for a little bit of paraphrasing.
Rules-based standards prescribe for the preparer what to do in contrast to a principles-based approach that emphasizes how to decide what to do.
One concern about a principles-based system is whether an economic substance over form concept might lead preparers of financial statements to try and justify a specific accounting outcome with reference to commercial drivers in an attempt to manage earnings. Some believe a principles-based system would lead to even more earnings management than has existed in our current rules-based system.
One lesser known provision of SOX is for a study to be conducted of the need to adopt a principles-based approach to standard setting in the United States to replace our more rules-based system. IFRS is a principles-based system. US GAAP as promulgated by FASB is a rules-based system.
There are benefits and concerns to a principle-bases system. Discuss some of the benefits and concerns. Do you believe a rules-based or principles-based system will work better in achieving more useful information in audited financial statements? What role do ethics play in the effectiveness of each type of system?
Example of response:
In the United States, our standards of U.S. GAAP are set by using a rules-based approach, while in many other countries IFRSs are set by means of a principles-based approach. It’s important to understand the difference between the two when discussing both approaches. A rules-based approach is an approach based on the laws and regulations in place. A principles-based approach is based on professional judgement. In other words the rules-based approach is concerned with “form over substance”, while the principles-based approach is concerned with “substance over form”.
There are benefits and concerns for both approaches. The rules-based approach follows the standards and thus sets structure that can leave little room for interpretation. The main benefit of this approach is the enforceability by accountants and auditors of the standards. A concern that has presented itself is that the “rules-based standards often provide a vehicle for circumventing the intention of the standard.” Examples of those who circumvented the rules would be Enron and WorldCom. The principles-based approach allows for the use of one’s professional judgement under a facts-based circumstance. Benefits for this approach are that it allows for the use of professional judgement, the handling of rapid changes in business, and changes in the same old checking of boxes routine. Concerns with this approach include that difficulties may arise for enforcement of the standards, as well as, the comparability of information from one period to the next. There would be a lack of guidance and structure available if professional judgement is the main deciding factor. This lack of guidance and structure could lead to more earnings management, which can be viewed as the cause for some frauds in recent years, such as Waste Management and HealthSouth.
In review of the recent fraud cases, it is clear that a rules-only approach or a principles-only approach would be opening our standards to the same weaknesses of the past. I believe a hybrid approach would be the best solution when setting standards. As we discussed in chapter 8, there is a need for both quantitative and qualitative information when we need to make an informed decision about materiality. The same discussion could be applied here with the rules vs. principles-based approaches. The use of both approaches is beneficial for all. We need the structure of the rules as well as the freedom to use our professional judgement to properly report the most useful financial information. Whether we can implement this by adopting IFRS is still yet to be seen, if ever. As daunting as this task may prove to be, it is imperative.
One way of executing a hybrid of the two approaches would be adding ethics. Ethics is a key factor when implementing both approaches. Ethics brings both approaches together and allows for the approaches to coincide with one another. In effect, the rules should support the principles.
Whether following U.S. GAAP or IFRS, there is one thought that we should all consider. “While ethical standards may vary, one truth does not: Honesty, integrity, and trust are the bases for sound business relationships.”