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.

Making Judgment Professional

According to a 2013 Financial Reporting Commentary by Staff of Canada’s Accounting Standards Board, the debate over principles-based standards vs. rules-based standards has gone on for many years. All standards should be based on principles. There also needs to be some amount of guidance in the standards on how to apply those principles. The question is how detailed or rules-like should guidance be? What is the balance that provides enough guidance to apply the standards in a consistent manner – but still leaves sufficient flexibility for financial statements to provide information about the entity in a way that is most helpful to users?

Detailed guidance makes it easier to determine the accounting for specific transactions and events – just check the rules. It also makes consistent application of the standards more likely. However, in some circumstances rules may not result in financial statements that provide the most relevant information. This is because those writing the standards often cannot foresee all the different types of transactions and circumstances that the rule will be applied to. In the extreme, detailed rules can become a straightjacket that limits the ability of financial reporting to provide information that meets user needs. Detailed rules can also make it easier to structure transactions to achieve a certain accounting result that is contrary to the underlying principles of the standard.

Professional judgment searches for the accounting that best meets the objective of financial statements – communicating information to financial statement users that helps them in making resource allocation decisions and assessing management stewardship – and is consistent with primary sources of GAAP. This is the test that must be met when applying professional judgment. In many cases, it will be clear there is only one method of accounting that meets this test for a specific transaction or event. However, differences in key facts or circumstances may result in different accounting being appropriate for similar transactions or events.

Read more about this Commentary on Making Judgment Professional and the ongoing debate over principles-based standards vs. rules-based standards.

The Background of Professional Judgment in Statutory Audit

According to a recent doctoral thesis, the issues of the professional judgment, known in the international literature as “judgment and decision–making process” have an inter-disciplinary character, being treated in such domains as psychology, medicine, law and accounting. The professional approach to this process offers a high level of complexity, which is also revealed by the large number of research papers from the specialized literature. This highlights the diversity of the factors that contribute to the substantiation of the professional judgment and of the decision making process.

The thesis continues this research, focusing on the auditing-accounting activity area. Accordingly, it studies the notion of professional judgment seen both as a general concept and as a multi-professional perspective, in order to be able to identify the general elements that define and characterize the process of the professional judgment. The most discussed subjects refer to the wide range of factors that contribute to the reasoning realization or to the divergent opinions regarding the approach based on principles or rules. The application of a professional reasoning which starts from well defined principles offers a broader scope for auditors to apply their experience, knowledge and abilities acquired over time, while constraining the activity in a set of strict rules that encompass the perspective of a diversified approach to the problems that professionals face.

To learn more, refer to the 2012 thesis on “The Background of Professional Judgment in Statutory Audit” by Phd Student Georgeta Ancuţa Șpan, Faculty of Economic Sciences and Business Administration, Department of Accounting and Auditing, Babeș-Bolyai University.

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.

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.