Accounting: Principle rules

Arguments for principles-based accounting are seductively simple. Principles-based accounting provides a comprehensive basis for preparing financial statements with the flexibility to deal with new and different situations.

Principles have found favour over rules, post-Enron. In the US, the view initially took hold that if rules-based accounting standards allowed the failure of Enron to develop undetected, then it should not continue. The argument against cookbook accounting is that it leads to the pejorative charge of box-ticking. The pragmatic would argue that in today’s complex world where so much is expected of corporate reports and those who prepare and audit them – and where the cost of mistakes are so high for all involved – that ticking the boxes is the only sane answer. This position to date has been shared by the International Accounting Standards Board.

That, however, should change according to the authors of a report, Principles-based or rules-based accounting standards – a question of judgement, published by the Institute of Chartered Accountants of Scotland. The report argues that global convergence of accounting standards cannot be achieved by a rules-driven approach. The argument for principles, not rules, is that rules-based accounting adds complexity, encourages financial engineering and does not necessarily lead to a “true and fair view” or a “fair presentation”.

A rules-based approach also hinders accounting standards being translated into different languages and cultures. To achieve the goal of principles-based standard setting would require a radical change in the global profession in order that preparers and auditors of accounts assume more responsibility for making judgements and seek less detailed guidance from standard setters and regulators. This requires the willingness of regulators to accept a broader range of judgement-based outcomes. A single interpretative body would have to b e created to focus on significant issues rather than detailed matters. Detailed matters should be left to the judgement of preparers and auditors with clear disclosure of how that judgement has been exercised. This may make theoretical sense, but would require a bonfire of accounting vanities the like of which none of us have seen. The present system may be imperfect, but at least the roles of all the players are established.

The vested interests are too entrenched. Standard-setters complain that they are criticised because they produce rule-based standards, but claim they do so only because they are asked to answer so many specific, detailed questions from accounting experts within the big firms or large corporates. Over the decades, the willingness and ability of auditors to hold in check their clients through the exercise of good professional judgement is, at best, unclear. The amount that auditors and finance directors disagree is still one of the great secrets in corporate governance and corporate reporting.

The view remains that executives will challenge auditors by asking, “Where is the rule that says such a proposed action is prohibited?” You can’t blame auditors for preferring a situation where, if a client challenges their views, other audit firms will give the same answer because all are applying the same rule, so reducing the risk of losing clients to alternative opinions. The report from the Scottish institute points out that it has been suggested that the difference between principles and rules is that rules must be argued against, but principles must be argued for. This requires a different professional attitude and it must be questioned whether firms possess such an attitude.

But perhaps more important is the fact that within the context of global financial reporting, a greater spectrum of views exist than when accounting standards were primarily national concerns about a principles framework aimed at convergence, consistency and comparability. Principles in accounting involve judgements based on society’s views of acceptable conduct, gaining such a consensus is becoming harder not easier. In order for principles to prevail there has to be sufficient common ground.

While the pros and cons of principles versus rules have most impact on standard-setters, preparers and auditors, it will inevitably have an impact on users of financial information. One of the key objectives of financial reporting is ‘comparability’ which usually means identical accounting treatment for all transactions of a defined class, but some argue that comparability allows users of accounting information to understand the underlying economic reality of the transaction. This latter approach does not require identical accounting; rather, it calls for a transparent and understandable approach to allow the user to make the comparison. A move towards principles could see the need for a shift in understanding of comparability and that would potentially give finance directors more freedom. The ‘principles versus rules’ accounting debate – which has rumbled on for decades sparked into life occasionally by corporate scandals or the emergence of a new accounting standard-setting regime – could rapidly evolve into a question of who makes the judgement, who sets the principles? If it is me, great; if it is you, I’d be a lot less keen.