Principles-based standards and professional judgment – Part 3 of 3

At a historic roundtable discussion in New York, the chairman (Charles B. Couchman) stated that: “For many years the leading practitioners of public accountancy have been reducing the practice of accountancy to rules and standards as far as it has been found practical and logical to do so. The elements that make up financial statements have been reduced to standard classifications to the extent permitted by complicated and constantly changing transactions of the business world. Rules have been adopted covering, to a large extent, the various entries affecting the financial classifications. These classifications and these rules have been made widely available through books, articles, addresses and accounting curricula. Practically all the progress that has been made in reducing accountancy to rules and standards has been accomplished by the public accounting profession.”

“If all of the transactions of business were susceptible to analysis into a definite and rigid number of effects that could be analyzed to an extent that would allow exact classification, then rules could be adopted that would cover correctly each one. However, that is not the case. No matter how long one is engaged in an extensive practice of accountancy, he is continually faced  by new and unexpected transactions, each legitimate but each presenting combinations of effects not previously encountered. That is why the sorting of accounting transactions is rigid classifications to which rules and standards may be applied without distortion of fact is a slow process and cannot be otherwise.”

“No fixed rule may be laid down until all of the accounting elements that may fall within its scope have been studied and their effects determined so completely as to bring exact knowledge that the rule, when applied to them, will result in a proper statement of financial facts. Even then the rule must be subject to possible exception, as there is always the possibility that a new and unexpected set of circumstances may arise to which the rigid application of this rule would result in distortion of truth.”

“It is true, not only of accountancy, but of almost every other complicated subject, that the one who has only a smattering of knowledge of it considers that the subject is reasonably simple and that he can readily devise rules governing each phase thereof. To the simple, all things are simple. It is only when one goes deeply into the subject, whatever it may be, that he becomes aware of the complications and the difficulties of proper treatment that is applicable to each element.”

To learn more about the history of the principles versus rules debate, read the transcript of an October 19, 1937 roundtable at the Waldorf-Astoria, New York titled “To What Extent Can the Practice of Accounting Be Reduced to Rules and Standards?” For more information and different perspectives regarding this ongoing debate, refer to Part 1 and Part 2 of this three-part posting as well as previous postings during the past year.

Principles-based standards and professional judgment – Part 2 of 3

Accounting research has shown that the distinction between rules-based and principles-based standards is not well defined and is subject to a variety of interpretations. Nonetheless, there is a commonly-held view that accounting standards in the United States are rules-based and International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) are principles-based.

A research paper published in 2006 identifies the basis of this distinction. For research and development, the paper compares the US standard issued by the Financial Accounting Standards Board (FASB) with two principles-based standards. For each standard, the researchers identify and classify rules and judgments, and observe the level of justifications for the rules and assistance to support the judgments. The three standards have rules, are based on principles, and require the exercise of professional judgment; the less conservative standard requires more judgments and, unexpectedly, more rules.

The results suggest that the rules-based versus principles-based distinction is not meaningful, except in relative terms. The paper concludes that a relatively more principles-based standards regime requires professional judgment at both the transaction level (substance over form) and at the financial statement level (‘true and fair view’ override). Furthermore, it suggests that any IASB and FASB convergence will require agreement on the weightings given to the qualitative characteristics.

Read the SSRN abstract and the full research article “Rules, Principles and Judgments in Accounting Standards” by Bruce Bennett (General Manager Admissions/Standards and Quality Assurance at the New Zealand Institute of Chartered Accountants), Michael Bradbury (Professor, School of Accountancy, Law and Finance, UNITEC Institute of Technology in Auckland, New Zealand, and a member of the International Financial Reporting Interpretations Committee of the IASB and the Financial Reporting Standards Board of the Institute of Chartered Accountants of New Zealand) and Helen Prangnell (a Senior Lecturer in the School of Accountancy, Law and Finance, UNITEC New Zealand, and a member of the Professional Practices Board of the Institute of Chartered Accountants of New Zealand).

This 16-page article and other articles on this debate were published in ABACUS, Vol. 42, No. 2, June 2006. For more information and different perspectives regarding this ongoing debate, refer to Part 1 of this three-part posting and previous postings during the past year.

Principles-based standards and professional judgment – Part 1 of 3

A recently-released research paper states that: “Although there is considerable support for the idea that a financial reporting system should be based upon ‘principles-based’ standards, progress in achieving this end has been slow. This paper argues that one of the reasons for the lack of progress is the vagueness of the idea of standards being ‘principles-based’.”

Furthermore, “The characteristics of such standards are identified through a conceptual enquiry into how standard setters, regulators and academics explain their nature. Superficial agreement on these characteristics masks disagreement about the reasons why these characteristics are thought to be desirable. These depend upon underlying assumptions about the nature of prescriptions in standards and about the purpose of providing implementation guidance in an accounting standard. The apparent agreement that ‘principles-based’ standards are a good thing is facilitated by the fact that this concept refers to a ‘boundary object’. With such concepts common characteristics allow for communication between parties who have different underlying interests and start from different assumptions about how those interests can be achieved.”

Nonetheless, “The failure to agree on these assumptions manifests itself in disagreement in the application of the concept to particular standards. This means that the concept is vague. Boundary objects may be useful for certain purposes, including political ones, but are not helpful in achieving the objectives of the current project of converging accounting standards. The paper concludes that a debate about fundamental issues about standard setting and accounting standards would be facilitated if the concept of ‘principles-based’ standards was abandoned.”

Read the 35-page research paper “Principles-based standards and judgement” published in 2012 by Dr Ian Dennis, Senior Lecturer in Accounting and Finance,, Oxford Brookes University Business School. For more information and different perspectives regarding this ongoing debate, refer to previous postings during the past year.

Exploring Principles vs. Rules-Based Accounting and Auditing Standards - Deloitte Fireside Chats

The Deloitte Fireside Chats are made possible through a partnership between Deloitte LLP and the SEC Historical Society. As noted in the previous posting (June 24, 2012), an interactive conversation on October 22, 2009 explored the role of professional judgment in accounting and auditing. On October 28, 2009, a further interactive conversation explored the issues surrounding principles versus rules-based accounting and auditing standards.

Patricia Fairfield, Associate Professor, McDonough School of Business, Georgetown University served as moderator. The two panellists were: Scott A. Taub, Managing Director, Financial Reporting Advisors, LLC and former Acting and Deputy Chief Accountant, SEC Office of the Chief Accountant; and Robert Kueppers, Deputy CEO of Deloitte and a trustee of the SEC Historical Society.

The discussion addressed a number of issues. ...What is meant by principles-based and rules-based accounting standards? What are the characteristics of ideal accounting standards? How can ideal standards be achieved? When we talk about principles versus rules, do we have any idea what we are talking about? The reality is that preparers, auditors, investors and regulators all have different needs but they would like to see the same economic substance portrayed in a way that is most useful and most transparent. There’s a lot at stake in this debate.

One of the seminal events in the debate was the Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. According to that Study, imperfections exist when standards are established on either a rules-based or a principles-only basis. "Principles-only standards may present enforcement difficulties because they provide little guidance or structure for exercising professional judgment by preparers and auditors. Rules-based standards often provide a vehicle for circumventing the intention of the standard. As a result of our study, the staff recommends that those involved in the standard-setting process more consistently develop standards on a principles-based or objectives-oriented basis."

In order to have a true principles-based accounting system, it isn’t just accounting standards that need to be written differently, but those applying the standards need to be thinking differently. There are implications for all parts of the financial reporting system, not just the writer of accounting standards. The term “objectives-based” or “objectives-oriented” recognizes that everybody has different views of what “principles-based” means. For example, a standard would set out the principles or objectives that the accounting for the particular item in the scope of that transaction is supposed to be looking towards. Then, those applying the standard would be charged with finding a method of accounting that is consistent with those objectives and principles.

...Yes, there might be implementation guidance but the purpose of the implementation guidance is to illustrate the principles and objectives, not to address specific fact patterns. An optimum amount of implementation guidance is going to require more judgment, more civil interchange with clients about what’s the best accounting and what’s the right answer. In this regard, those who look at the potential of a professional judgment framework as a panacea and those that look at it as a trap are misunderstanding the purpose of the judgment framework. The purpose is to get to better accounting answers, not to mandate a way to do things. It’s to help people who are applying accounting standards to make those judgments in an intelligent way.

To learn more about this debate, refer to the “Deloitte Fireside Chat – Part II: Exploring Principles vs. Rules-Based Accounting and Auditing Standards (October 28, 2009)” available as an Edited Transcript and as an Audio Recording on the SEC Historical Society website. Also, refer to the August 2011 postings on SEC Views on a Framework for Professional Judgment – Part 1, Part 2 and Part 3.