New ICAS survey: Principles not Rules

Is the principles not rules debate still valid in today’s corporate reporting landscape? What are the challenges in implementing principles-based standards? These were some of the questions for debate at an ICAS event to mark the 10 year anniversary of the 2006 publication of 'Principles not Rules: A question of judgement'.

The Institute of Chartered Accountants of Scotland (ICAS) recently surveyed members with an interest in corporate and financial reporting on their views on this debate. A similar survey was undertaken in 2011. 

Of the 199 respondents to the survey, the key findings were as follows:

• 90% of respondents had a preference for principles;

• 64% believe IFRS is very or mainly rules-based;

• 61% think that IFRS has become more rules-based in the last five years;

• There was very strong support for the idea that the profession is capable of operating within a principles-based environment;

• The main barriers to principles-based standards were considered to be:  the influence of US GAAP; the role of regulators in challenging judgments; the threat of litigation; and the lack of trust in preparers and auditors.. 

For a summary of the full results of this survey, see ICAS survey: Principles not Rules. To learn more, refer to previous postings about the principles versus rules debate.

Perceptions of CPAs and CFOs about Principles-Based versus Rules-Based Accounting Standards

Although there appears to be a widespread agreement that principles-based standards are superior to rules-based standards, little has been done to test this consensus. Accordingly, recent research was done to investigate the perceptions of CPAs and CFOs in the United States. A survey was sent to a random sample of 500 CPAs who were practicing auditors from public accounting firms that have substantial publicly-traded companies as clients. The research instrument was also sent to 500 CFOs from the Fortune 1000.

The survey comprised 11 brief definitions of qualitative characteristics of financial reporting along with demographic questions. To place the respondents’ observations in context, the research focused on their views regarding whether the two regimes were likely to attain the qualitative characteristics of financial reporting included in the Conceptual Framework for Financial Reporting updated by FASB in September 2010 and the corresponding document updated by the IASB at the same time. Also included was a question on professional judgment that was derived from a white paper, “Principles- Based Accounting Standards” published by the major accounting firms in 2008.

The research found that there were no significant differences between the answers provided by auditors and the answers provided by CFOs for any of the questions. The first observation to draw from the data is that there is no consensus among CPAs that one accounting regime is better than another along all the dimensions analyzed. The second observation is that there is strong support for both regimes with respect to each concept. The third observation is that there are a few concepts where respondents thought one regime would have a very significant advantage over the other. For example, with respect to whether financial statements will allow for the use of professional judgment in considering whether the accounting representation is consistent with economic reality, nearly all (91%) found a principles-based regime to be preferable.

To learn more, read the article “CPAs’ and CFOs’ Perceptions Regarding Principles-Based Versus Rules-Based Accounting Standards” in the March 2012 issue of The CPA Journal. The research was undertaken by John McEnroe, DBA, CPA, and Mark Sullivan, PhD, CPA, both in the school of accountancy and management information systems at DePaul University, Chicago, Illinois, USA. Also, refer to the ICAS paper “Principles- Based or Rules-Based Accounting Standards: A Question of Judgement” published in 2006.

Promoting Professional Judgment by Objectives-Oriented Accounting Standards

A 2013 study “analyzes how the International Accounting Standards Board (IASB) promotes professional judgment by issuing objectives-oriented accounting standards and exposure drafts.” The focus is on the role of judgment as outlined in Phase I of the IASB 2010  Conceptual Framework, Chapter 1 - Objective of General Purpose Financial Statements and Chapter 3 - Qualitative Characteristics of Useful Financial Information.

This research discusses how the Conceptual Framework, through objectives-oriented accounting standards, encourages professional judgment as recommended by the United States Securities and Exchange Commission (SEC) in its 2003 Report, 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.

The research findings indicate that the five IFRS issued after the 2010 Conceptual Framework are objectives-based, but the eight issued before then are not.. Specifically, the objectives-based IFRS clearly stated the objective, they are based on the Framework without significant exceptions and bright-lines and they provide adequate application guidance. More significantly, a framework for judgment is provided.

The study concludes that: An increasingly complex financial environment demands accounting standards that narrow the range of professional judgments in accounting decisions. Although new accounting principles and approaches do not eliminate the necessity of judgments entirely, the IASB's process of improving transparency and comparability of financial reporting hinges on its ability to promote professional judgment. It depends on the standard setter and the practitioners. The IASB is issuing more objectives-based standards that provide a framework for judgment. Professional accountants, auditors and managers need to be cognizant of the IASB's efforts so they can cooperate in the pursuit to judgment.

The research paper is available online at International Journal of Business and Social Research (Vol 3, No 7 (2013). For more information, refer to The International Accounting Standards Board’s Progress in Promoting Judgement through Objectives-Oriented Accounting Standards by Tanja Lakovic and Jayne Fuglister, Faculty of Economics, University of Montenegro.

Applying IFRS - Online guidance and resource materials

The Chartered Professional Accountants of Canada (CPA Canada) maintain an IFRS web section to provide guidance and support for understanding and applying International Financial Reporting Standards (IFRS). Whether applying an existing standard, searching for information on new standards, preparing financial statements or communicating with clients or lenders about IFRS, check out these free online resources. The Reporting Alerts series summarizes new and revised standards.

In addition, the Viewpoint series discusses circumstances unique to the mining and the oil and gas sectors. CPA Canada and the Prospectors and Developers Association of Canada (PDAC) created the Mining Industry Task Force to share views on IFRS application issues of relevance to junior mining companies. CPA Canada, the Canadian Association of Petroleum Producers (CAPP) and the Explorers and Producers Association of Canada (EPAC) created the Oil and Gas Industry Task Force to share views on IFRS application issues of relevance to junior oil and gas companies. In addition, learn more about the importance of applying professional judgment when preparing or auditing IFRS-based financial reporting.

IASB Discussion Paper - A Review of the Conceptual Framework for Financial Reporting

In July 2013, the International Accounting Standards Board (IASB) issued a Discussion Paper called “A Review of the Conceptual Framework for Financial Reporting.” The Paper sets out the principles underpinning the International Financial Reporting Standards (IFRS). It provides stakeholders with an opportunity to shape the future of financial reporting. The 239-page Discussion Paper, providing 26 questions for respondents to consider, is available for public comment until January 14, 2014.

In 2011, the IASB carried out a public consultation on its agenda. Most respondents to that consultation identified the Conceptual Framework as a priority project for the IASB. Consequently, the IASB decided to restart its Conceptual Framework project, which had been suspended in 2010.

This Discussion Paper is the first step towards issuing a revised Conceptual Framework. It is designed to obtain initial views and comments on a number of matters, and focuses on areas that have caused the IASB problems in practice. Consequently, this Discussion Paper does not cover all the issues that the IASB would expect to cover in an Exposure Draft of the Conceptual Framework. The Discussion Paper sets out the IASB’s preliminary views on some of the topics discussed. However, the IASB has not reached preliminary views on all of the issues discussed in this Discussion Paper.

The Discussion Paper addresses the definitions of assets and liabilities, recognition and de-recognition, the distinction between equity and liabilities, measurement, presentation and disclosure, and other comprehensive income. For an overview, see the July 23, 2013 article “IASB seeks feedback on conceptual framework revision” in the Journal of Accountancy online.

Promoting Judgment through Objectives-Oriented Accounting Standards

A recently-published study analyzes how the International Accounting Standards Board (IASB) promotes professional judgment by issuing objectives-oriented accounting standards and exposure drafts. The authors focus on the role of judgment as outlined in Phase I of the IASB Conceptual Framework, Chapter 1, “Objective of General Purpose Financial Statements” and Chapter 3, “Qualitative Characteristics of Useful Financial Information” (IASB 2010).

This study discusses how the Conceptual Framework encourages professional judgment, when viewed through the prism of objectives-oriented accounting standards. Such an approach was recommended by the United States Securities and Exchange Commission (SEC) Report in its “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” (July 2003).

The study also analyzes International Financial Reporting Standards (IFRS) and Exposure Drafts issued by the IASB since its inception in 2002 to determine if those documents are consistent with objectives-oriented accounting standards. This analysis is useful for gaining insights into how the IASB integrates the Conceptual Framework with the SEC’s recommended objectives-oriented accounting approach to promote judgment in the interest of IASB/FASB convergence of accounting standards.

According to the study, “An increasingly complex financial environment demands accounting standards that narrow the range of professional judgments in accounting decisions. Although new accounting principles and approaches do not eliminate the necessity of judgments entirely, the IASB’s process of improving transparency and comparability of financial reporting hinges on its ability to promote professional judgment. Its ability depends on the standard setter and the practitioners. The IASB is issuing more objectives-based standards that provide a framework for judgment. Professional accountants, auditors and managers need to be cognizant of the IASB's efforts so they can cooperate in the pursuit to judgment.”

For more information, refer to the 15-page research article “The International Accounting Standards Board’s Progress in Promoting Judgement through Objectives-Oriented Accounting Standards” by Tanja Lakovic and Jayne Fuglister at the University of Montenegro. The article was published in the International Journal of Business and Social Research, Volume 3, No. 7, July, 2013.

Principles-Based Reasoning about Accounting Estimates

Wally Smieliauskas, PhD

According to the abstract, this research article proposes a key principle and related concepts for reasoning about accounting estimates. The reasoning is consistent with a principles-based professional judgment framework proposed by Ross Skinner and the Institute of Chartered Accountants of Scotland. The principle deals with reasonable ranges and related risk assessments in the audit of accounting estimates. It does so by using concepts first introduced by Boritz and Skinner and updates them for the requirements of CAS/ISA No. 540 and International Financial Reporting Standards (IFRS).

The article identifies the conditions for the existence of the benchmark ranges proposed by Wally Smieliauskas in identifying fairly presented estimates. The need for a professional judgment framework and related guidance has been recognized recently by the International Federation of Accountants (IFAC), a 2010 EU Green Paper, and the Public Company Accounting Oversight Board (PCAOB) as a result of challenges auditors have been facing in the current reporting environment. This recognition echoes calls first made by Ross Skinner in his pioneering 1995 article, and reinforced by the FASB/IASB 2006 proposal for principles-based accounting standards.

The full article “Principles-Based Reasoning about Accounting Estimates” by Wally Smieliauskas is available from the Wiley Online Library (published in AccountingPerspectives, Volume 11, Issue 4, pages 259–296, Winter 2012).

International Financial Reporting Standards and Aggressive Reporting: An Investigation of Proposed Auditor Judgment Guidance

In a recent research paper, the authors investigate auditors’ judgments under accounting standards that differ in their precision. After establishing conditions under which auditors accept managements’ aggressive financial reporting, the paper examines the effectiveness of alternative judgment frameworks in helping auditors curb this aggressive reporting under less precise International Financial Reporting Standards (IFRS) and more precise US GAAP.

 

One of the frameworks is based on the Securities and Exchange Commission’s (SEC) Advisory Committee on Improvements to Financial Reporting’s (CIFiR) recommendation to use counterfactual reasoning. Another framework based on Construal Level Theory requires auditors to think broadly about a transaction, while the last framework is based on both counterfactual reasoning and Construal Level Theory.

 

The research paper finds that auditors’ ability to restrain managers’ opportunistic judgments under less precise IFRS depends on the economic substance of the transaction. It also finds that a judgment framework helps auditors curb managements’ aggressive accounting under IFRS. Additionally, the judgment frameworks based on Construal Level Theory are more effective than the framework based on CIFiR’s proposed judgment guidance when the transaction’s economic substance is clear, while the framework based on CIFiR’s proposed guidance is just as effective when the economic substance is unclear. These results inform regulators, standard-setters and auditors on the effectiveness of different judgment guidance in improving auditors’ judgments under less precise IFRS.

 

To learn more, refer to the 45-page research article “International Financial Reporting Standards and Aggressive Reporting: An Investigation of Proposed Auditor Judgment Guidance” by Ann G. Backof (University of Virginia - McIntire School of Commerce), E. Michael Bamber (University of Georgia) and Tina Carpenter (University of Georgia) posted on January 21, 2011. Also, refer to the August 2011 postings on SEC Views on a Framework for Professional Judgment – Part 1, Part 2 and Part 3.

Should Accounting Standards be Principles or Rules?

In a recently-published article, Sir David Tweedie notes that: “Forty-odd years ago, as a CA apprentice, I didn't have to study accounting standards because there weren’t any! There was one major standard – the true and fair view – augmented by accepted practice.” According to Tweedie, two disputed takeover bids soon changed that. The President of the Institute of Chartered Accountants in England and Wales (ICAEW), Sir Ronald Leach, senior partner of Peat Marwick & Co., and Professor Edward Stamp of Edinburgh University became embroiled in a public argument in the pages of The Times over the state of British financial reporting.

 

“Professor Stamp argued that for any major company, there would be a million ways which you could show a true and fair view, and that this was totally unacceptable. Sir Ronald reacted with alacrity, and together with the other Institutes (including a rather reluctant ICAS), agreed to form the Accounting Standards Steering Committee in 1969. Pressured by the Government, the Committee looked for a quick win and came upon a research paper of the ICAEW dealing with Associated Companies. This was rapidly turned into the Statement of Standard Accounting Practice 1. While to accountants such a topic would be a bizarre choice for the first standard, rather than what became SSAP2 – Accounting Policies – the profession needed to show it.”

 

“The argument continues over whether standards in financial reporting can best be governed by clear and detailed rules, or by principles and judgement could act quickly in a time of crisis. Since then, we have seen the SSAPs gradually replaced with Financial Reporting Standards and latterly by International Financial Reporting Standards (IFRS). These standards have become more and more complex.”

 

“Accounting is not rocket science. Writing a standard to deal with 80 per cent of the problems takes only a few pages, yet if our profession requires every avenue to be explored, then it can run into hundreds. ICAS is just completing a judgement framework to assist professionals who are unsure what exactly judgement involves. If you have been trained in what I term ‘search-engine’ accounting – looking up the answer in a massive book of rules –judgement can be scary.”

 

“The profession is at a crossroads, and the more we head down the rules route the harder it will be to pull back to simpler, more clearly expressed principle-based standards.” Read the article “Should Accounting Standards be Principles or Rules?” by Sir David Tweedie, President of the Institute of Chartered Accountants of Scotland (ICAS), as well as previous postings regarding the Principles versus Rules debate.

A professional judgment framework for financial reporting

The Institute of Chartered Accountants of Scotland (ICAS) has been pursuing a campaign in support of principles-based financial reporting standards since the publication of Principles not Rules: A Question of Judgement in 2006. According to the ICAS, principles-based standards provide a framework within which the economic substance of transactions can be faithfully presented and better serve the needs of business and markets, and the public interest.

 

 

The key to the effective functioning of a principles-based framework is the ability of preparers and auditors to exercise professional judgment in the application of principles to the circumstances of a particular transaction or accounting issue. The basis of such judgments needs to be properly documented, so that regulators (who also need to have the experience and expertise to consider and challenge such judgments) can assess the reasonableness of the judgments based on the facts and knowledge available at the time of the judgments.

 

In an effective principles-based environment, each party plays a key role in making their own judgments and challenging others’ judgments, building up trust that all the parties have sufficient experience and expertise and that they approach their different roles in a proportionate and sensible manner. In the light of comments received on earlier work and involvement in similar work undertaken by the Global Accounting Alliance (GAA), there is a need for guidance on how to make judgments, especially in jurisdictions which are first time adopters of International Financial Reporting Standards (IFRS) or which are used to operating in a prescriptive or rules-based environment.

 

The ICAS has therefore developed A Professional Judgement Framework for Financial Reporting: An international guide for preparers, auditors, regulators and standard setters which offers guidance that may be useful around the globe. Other postings regarding a “professional judgment framework” may also be useful.

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.

It’s Time for Principles-Based Accounting Ethics

The American Institute of Certified Public Accountants (AICPA) has promulgated a Code of Professional Conduct, which has served as the primary ethical standard for public accountants in the United States for more than 20 years. It is now out of date and needs to be replaced with a code of ethics. It suggests, for example, that accountants should "exercise sensitive professional and moral judgments in all their activities" and should seek to "continually demonstrate their dedication to professional excellence." Just as US generally accepted accounting principles are being migrated toward "principles-based accounting" as part of a convergence with International Financial Reporting Standards (IFRS), a similar process needs to occur with ethics.

The primary rules of the AICPA Code around five essential virtues: objectivity, integrity, inquisitiveness, loyalty and trustworthiness. These virtues correspond to the general principles set forth in the Code of Ethics for Professional Accountants of the International Federation of Accountants (IFAC). The IFAC code establishes a conceptual framework that requires a professional accountant to identify, evaluate and address threats to compliance with the fundamental principles. The conceptual framework approach assists professional accountants in complying with the ethical requirements of the code and meeting their responsibility to act in the public interest.

From this virtue ethics perspective, various rules of the AICPA Code are seen as being inadequate, at best, and poorly crafted, at worst. Principles-based ethics serve the profession and the financial reporting process better than the current rules-based approach. To learn more, read the article “It’s Time for Principles-Based Accounting Ethics” by Albert D. Spalding Jr. and Alfonso Oddo, published online January 6, 2012 in the Journal of Business Ethics.

Professional Judgment and Principles-based International Financial Reporting Standards

In a Statement before the Subcommittee on Securities, Insurance and Investment of the United States Senate in Washington, D.C. (October 24, 2007, p. 10), Sir David Tweedie, Chairman of the International Accounting Standards Board (IASB), emphasized that a shift to less rules-based principles will increase the need for judgment. He stated: “A principle-based standard relies on judgments. Disclosure of the choices made and the rationale for these choices would be essential. If in doubt about how to deal with a particular issue, preparers and auditors should relate back to the core principles. The basis for conclusions (the rationale underlying a particular standard and published with it) should also include, in particular, the question of whether there is only a single view to tackle the economics of the situation. Often there are competing views—is one regarded as more relevant? If so, the reasons for choosing that particular view should be explained in the basis for conclusions and the reasons for rejecting the others clearly outlined.”

Because they are viewed as principles-based, International Financial Reporting Standards (IFRS) raise pervasive judgment issues (such as going concern, materiality and related disclosures) and application judgment issues (including presentation and disclosure, classification, recognition, de-recognition and measurement) for financial statement preparers, auditors and regulators. In fact, the need to exercise sound professional judgment on a continuous basis (perhaps 100,000 times a day around the world) was noted by Robert P. Garnett Chairman, International Financial Reporting Interpretations Committee (IFRIC) in a YouTube presentation called “Professional judgment gets used in the interpretation of standards” on November 29, 2008.