Rules-based and principles-based accounting standards

(A) Rules-based accounting standard

Rule-based systems are fairly simplistic, consisting of little more than a set of if-then statements, but provide the basis for so-called "expert systems" which are widely used in many fields. The concept of an expert system is this: the knowledge of an expert is encoded into the rule set. When exposed to the same data, the expert system AI will perform in a similar manner to the expert.

Rule-based systems are a relatively simple model that can be adapted to any number of problems, rule-based systems are really only feasible for problems for which any and all knowledge in the problem area can be written in the form of if-then rules and for which this problem area is not large.

If there are too many rules, the system can become difficult to maintain and can suffer a performance hit.

Rules-based accounting provide a list of detailed rules to follow, the list of rules clearly tell you how to do and provide the exactly format, no any professional judgments is needed.

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Advantages of Rules-based accounting standard

(1) The rules can increase the accuracy with which standard setters communicate their requirements and increase comparability.

(2) The rules increase verifiability for auditors and regulators and a related reduction in litigation.

(3) The rules reduced opportunities for earnings management through judgments, can reduce the sort of imprecision that lead to aggressive reporting choices by managements.

Disadvantages of Rules-based accounting standard

(1) 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.

(B) Principles-based accounting standard

Principles-based accounting provides a conceptual basis for accountants to follow instead of a list of detailed rules.

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.

A principles-based approach is more likely to provide flexibility and concept /idea to the accountants, and to result in transactions that reflect their true economic substance.

Advantages of principles-based accounting standard

(1) 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. Providing broad guidelines may improve the representational faithfulness of financial statements.

(2) It allows 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 rules-based accounting standards.

(3) Principles would result in simpler standards, it would be easier to comprehend and apply to a broad range of transactions because standards are developed based on rules. Rules are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent."

(4) The use of principles-based accounting standards may provide accounting statements that more accurately reflect a company's actual performance because an increase in principles-based accounting standards would reduce manipulations of the rules (Nationwide News, 2002).

(5) A principles-based standard often becomes a rules-based standard in an effort to increase comparability and consistency, when there is a problem that standards setters approach the difficult task of determining the appropriate level of detailed guidance to achieve sufficient comparability and consistency in financial statements.

Disadvantages of Principles-based accounting standard

(1) A lack of precise guidelines could create inconsistencies in the application of standards across organizations. 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.

(2) Principles-based accounting 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.