This article is the second in a series of articles that takes our readers on a journey through International Financial Reporting Standards (IFRS) with a special focus on the standards’ quintessential feature: they are principles-based. This article provides an overview of the concept of a principles-based set of standards (IFRS) as opposed to a rules-based set of standards (U.S. generally accepted accounting principles or GAAP).
The debate regarding whether U.S. issuers will be allowed to prepare their financial statements using IFRS has been around for a few years. Regulators in the United States want to make sure that all potential impacts have been analyzed thoughtfully before a final decision is made. To better understand the debate between a principles-based set of standards and a rules-based set of standards, it might be useful to first analyze what are commonly identified as some of the benefits of each of these approaches:
| Principles-based Set of Standards |
Rules-based Set of Standards |
| Better able to cope with speed of change of business environment |
More workable in large, complex economies and countries |
| More workable in large, complex economies and countries |
Less voluminous Less room for interpretation |
| Encourages use of professional judgment with a focus on what is right |
Provides more guidance for practical implementation |
| Seen as possibly discouraging financial engineering |
Less need for explanation in financial statements |
In the United States, many people believe that U.S. GAAP has served the most successful, dynamic and growing economy of the modern era, and wonder why it should be replaced. Many who support a rules-based set of standards believe that a large and complex economy like that of the United States needs rules, whereas principles are workable only in smaller countries. They think that with so many cultures and business environments, it is a real challenge to develop principles that are robust and workable in all jurisdictions. Their view is that a rules-based system where there is less room for interpretation could actually result in less complex and more transparent financial statements, as there would be less need for explanation. With the United States characterized by a pervasive litigious environment dominated by a prescriptive and very legalistic regulatory framework, moving toward a more principlebased approach for accounting standards might represent a leap with difficult-to-predict consequences.
In general it appears that, at least outside the United States, a strong consensus has emerged in favor of principles and the use of judgment versus rules. Supporters of a principles-based set of standards believe that principles are about common sense and what is right. They think that, by definition, business decisions are judgmental and such a judgmental component cannot be eliminated. In their view, the purpose of accounting should be to fairly depict economic reality and the judgmental component is an integral part of the economic reality. Those who support a principles-based approach believe that failing to emphasize and appropriately bring to the surface the judgmental component of financial reporting can result in misleading information for the users of financial information. In a principles-based context, the tenacious desire for “bright lines” tends to be seen as a search for artificial borders that might result in an illusionary one-size-fits-all answer to the inherent economic uncertainty.
We would like to point out that possibly the debate is not about whether we should have principles only or rules only. IFRS include guidance and in some cases are closer to a set of rules than a set of principles.
Also, it might not be entirely accurate to refer to U.S. GAAP as a rules-based set of standards. After all, the “P” in “GAAP” stands for “principles.” U.S. GAAP was born as a set of principles; however, over the years, a rules-driven approach has prevailed and as a result, it fairly depicts where U.S. GAAP stands along the principles vs. rules continuum. Hence, in practice, when visualizing the principles vs. rules continuum, it might be more appropriate to focus the discussion on how close to the “pure principles approach” extreme IFRS should be positioned.
Source: McGladrey & Pullen (www.mcgladrey.com) |