The parade of corporate accounting scandals of the last decade, with lion’s share occurring in 2002, has developed deep antipathy and distrust towards corporations and their reporting practices, and casted doubts on the opinions of audit firms. As majority of these accounting frauds occurred in the US (See Appendix), there was a widely-held view that rules-based accounting standards have allowed failure of large corporations like Enron and World Com, since US GAAP is perceived to emphasize on the rules-based approach to standards setting. This in its turn has put enormous pressure towards the US regulators and standard setters to relook into roots of accounting standards to regain public confidence and investor trust in the financial markets (Lev, 2012).

The first major regulatory response was Sarbanes-Oxley Act of 2002 (Sarbox), which sparked a hot debate between rules-based versus principles-based accounting standard supporters. In this paper, we shall distinguish between these approaches and provide synthesis of arguments supporting each approach from the existing literature. Based on these explanations, we conclude that choice between rules and principles based approach can be difficult, give some view on dual classification of approaches to standard setting.

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Defining and Distinguishing Rules and Principles

Although US GAAP are generally considered to be rules-based and International Financial Reporting Standards are claimed to be based on principles and require professional judgment (Schipper, 2003), the distinction between rules-based and principles-based standards is not well defined and can be variedly interpreted (Bennett et al, 2006). The clarifications on the meaning of rules and principles and their dissimilar features can be found in the legal and accounting literature. The definitions in the legal literature are important stepping stone for more complex and industry-specific definitions in the internal realm of accounting research.

Generally speaking, legal scholars distinguish rules and principles in accordance with degree of specificity and level of judgment required (Wüstemann and Wüstemann, 2010). For example, Braithwaite (2002) argues that principles are vague prescriptions and rules are specific prescriptions. Similarly, Cunningham (2007) asserts that principles are vague as they provide negligible ex-ante guidance, whereas, rules are very specific as the offer more a priori guidance. He also claims that principles require decision maker to use judgment when applying them, whilst, rules leave almost no room for judgment.

Accounting literature is generally in conformity with the definitions provided in the legal literature: many accounting scholars as well as regulators describe rules as being very detailed that they clearly list exact accounting treatments for specific transactions or events. Principles are characterized as general guidelines that call for judgment with respect to the accounting issue at hand rather than providing details of how these guidelines should be implemented (Psaros, 2007).

Although accounting literature agrees with definitions provided by legal scholars, there are some internal industry-specific considerations as well. For example, some researchers note that accounting rules contain quantitative borderlines (often referred to as “bright-lines” in accounting literature), exceptions and sometimes inconsistencies. Others claim that principles are originated from full and consistent conceptual framework (Bonham et al., 2009). If we consider these additional definitions in terms of legal literature, we can see rules do not necessarily contain quantitative thresholds, exceptions and inconsistencies, and can be also be derived from a full and internally consistent array of high-level objectives (Wüstemann and Wüstemann, 2010).

Such additional definitions represent mere reflection of deficiencies in the U.S. standards, which have become so precise that many feel they invite opportunistic interpretation by corporations, which accounting literature wants to improve by making standards lean towards principles-based approach. This may explain why rules-based approach to standard setting has become fairly unpopular, especially after witnessing corporate accounting scandals, like that of Enron, World Com and many others of 2002 and ad-hoc ones that happened throughout the decade: Parmalat – 2003, AIG - 2004, Lehman Brothers – 2009, Olympus – 2011, etc (See Appendix).

To see the distinction between rules and principles, we give example of leases. Canadian accounting standards state that a lease can be capitalized when “substantially all the benefits and risks of ownership have been transferred to the lessee”. Three criteria serve as guideline to evaluate whether all benefits and risks have been transferred. In the US standard if any of the same 3 criteria (shown as 4 rather than 3) are met, lease must be capitalized, if none, it must be expensed. Note that Canadian standards still allow preparer to look at the substance of the transaction and decide whether to capitalize it even if none of the criteria is satisfied. Hence, US standards are rules-based, whereas Canadian standards are principles-based (Beechy, 2005).

To sum up, although there are some differences in legal and accounting definition of rules and principles, they tend to agree that the principles are broad guidelines which user of standard relies upon when applying professional judgment. As our example showed in principles-based standards, the intention of the standard is utmost important for the user of the standard. Rules, on the other hand, mandate user of standard to follow specific guidelines when deciding on the accounting treatment of the event. Hence, rules-based approach retains a legalistic emphasis.

Comparing rules-vs-principles based standards

In this section we shall examine advantages and disadvantages of rules-based and principles-based standards, highlighted in the literature, from several dimensions, such as professional judgment (room for creative accounting and reflection of economic reality), enforcement, comparability / consistency, complexity.

Professional judgment:Economic Reality vs. Creative Accounting

It is often argued that professional judgment, much allowed in the principles-based accounting standards, if used correctly, enables to comply with the intent of the standards, suggests accounting treatment for special / individual cases, not foreseen by rules-based standards (Cunningham, 2007) and is more reactive to the changes in the business practices (Kivi et al, 2004).

Moreover, accountants and managers who exercise professional judgment possess the best information that can explain the economic reality within the firm and how to account for it. Indeed, Kivi et al (2004) argues that the most persuasive argument in support of principle-based standards is that due to professional judgment, economic reality of the firm can be revealed correctly. As we have seen in the example of operating leases, sometimes, when rules hinder economic substance, it might be necessary to use professional judgment. Professional judgment and choice of accounting treatment allow managers to communicate private information to the financial markets and, speaking with Akerloff’s analogy, enable investors to distinguish the good firm from “lemons”. Such signaling benefit of professional judgment has been highlighted by Hail et al. (2009).

On the other side of the coin, Beechy (2005) argues that even if managers have good intentions, they may fail to make relevant professional judgment, since they are always biased. The bias comes from many sources, for example, from the pressure to show good results in the short-term, i.e. meet and beat analyst forecasts to avoid stock price decline and/ or if manager’s compensation is tied towards company results or to bonuses that are in the form of stock options, etc (Guenther, 2005).

However, unsurprisingly, managers sometimes have fraudulent intentions, which was apparent during the wave of corporate scandals that happened in the early years of new millennium. Hence, principles-based standards that rely on professional judgment are often criticized for leaving room for earnings manipulations and creative accounting. On the other hand, rules based standards have been found to reduce earnings management (Benston et al., 2006, Ng, 2004). Ewert and Wagenhofer (2005) argue that when rules get stricter there is higher possibility of real earnings management, which is changing the structure of transactions or events to avoid specific accounting treatment stipulated by rules-based standards. However, such real earnings management comes at a real cost to shareholder value, in the form of unrealized positive NPV projects, underinvestment for research and development, etc.

An important paper from Nelson et al (2002) suggests that companies opt for real earnings management when standards are strict and do not allow for judgment. Auditors are not likely to detect such change in change in operations when structuring decision is consistent with precise rules. When standards are not strict and allow for professional judgment companies take advantage of such allowance – manage their earnings. Auditors are likely to agree with accounting treatment companies choose since rules are vague. Implication from this is that, if managers have intention for managing their earnings, they can do so regardless of whether standards are specific or vaguely defined.

Enforceability

Enforceability is the big disadvantage of principles-based standards compared to rules-based standards, especially in the litigious countries, like US. Enforcement of principles-based standards is difficult, since the principles are imprecise and allow for differing accounting treatment for the identical transactions (Cunningham, 2007). At the same time, there is high chance of litigation for preparers of principle-based standards (companies), since enforcement bodies may claim violation even if the permitted professional judgment was based on good intention (Dickey and Scanlon, 2006).

It can be argued that although Germany has principles-based standards, the litigation cases are very seldom apart from those on taxes, as compared to US. However, Krahnen and Schmidt (2004) argue that this can be due to the fact that Germany does not have strong enforcing and monitoring activities like that of US Security Exchange Commission. Therefore, there is much expectation that with the adoption of principles-based system in the US, there will be sharp increase in lawsuits (Hail et al, 2009). As for rules-based system, as long as preparers conform to precisely written rules, the cases for a lawsuit are lessened.

Comparability and consistency

Comparability and consistency is another important dimension of comparison between rules-versus-principles-based accounting. Choi and McCarthy (2003) argue that the issue of comparability is important in accounting literature, and much demanded by financial markets and regulators. For example, European law on application of IFRS aims at maintaining uniformity of consolidation methods. In general, it was found that rules-based standards lead to greater possibility of comparability since they are precise and do not normally lead to different treatment of same transaction as in the case of principles-based standards (Dickey and Scanlon, 2006).

However, even with uniform accounting standards (rules – based approach), it is difficult to say that company with higher earnings is better off compared to company with lower earnings. To see this point consider one of the criteria for recognizing liability - liability is only recognized if the probability of resource outflows is more than 50%. Two companies pending litigation, one might have to pay with 4% of probability and another with 40% of probability. Neither will record this liability and have same income, whereas economic situation is considerably different for two companies (Wüstemann and Wüstemann, 2010).

Complexity

In comparison to rules-based standard, principles-based accounting approach embodies simplicity, as it is easier to understand and apply to wider range of transactions. Survey conducted by Ng (2004) suggested that if US accounting standards will lean more towards principles-based approach, the volume of GAAP will be reduced considerably. In 2002 interview to Business Week, FASB Chair Robert Herz claimed that a principles-based system would lead to standards that would be less than 12 pages long, instead of over 100 pages (Shortridge and Myring, 2004). Complexity also leads to slow process of setting standards rules-based system. On the other hand, real world cases can be more complex, or some industries, like financial sector, require stricter regulation to operate efficiently and systemically safe. Therefore, creative accounting due to differently interpreted principles and possible loopholes may not be systemically plausible and correct in such cases (Weetman et al, 2006).

Conclusion

To sum up, rules-based accounting standards were blamed for a decade of corporate accounting frauds. It was widely accepted by literature and regulators that US standards should move towards becoming principles-oriented. In order to see whether such move solves the problem of fraudulent accounting, first, we distinguished rules-based accounting standards from principles based standards with respect to degree of specificity and level of judgment according to legal literature and, additionally, in terms of specific bright-lines, exceptions and sometimes inconsistencies as per accounting literature.

We then compared advantages and disadvantages of two extreme standards according to several dimensions. Professional judgment dimension suggested that principles based standards present real economic situation, signal private information to investors, can be broadly applied to individual cases. Moreover, if bad intention is in the minds of preparers, regardless of which standard you enforce, they can still avoid the rules. Enforceability and comparability were argued to be benefits of rules-based system, whereas simplicity is the advantage of principles-based system, although in some scenarios, comparability may not be achieved or complexity of standards might be required.

It can be summarized that there can a continuum of choices between rules-based and principles-based approaches, rather than this dual classification, which should embody best of the both worlds.