Stick to principles or go by the rules?

A new accounting standards regime could be emerging as the ‘principles versus rules' debate continues, warns Peter Williams

The arguments for principles-based accounting are seductively simple: it provides a basis for preparing financial statements with the flexibility to deal with new and different situations.

Principles have found favour over rules, post-Enron. In the US, the view initially took hold that if rules-based accounting standards allowed the failure of Enron to develop undetected, then it should not continue. The argument against cookbook accounting is that it leads to the pejorative charge of box ticking.

Today, when so much is expected of corporate reports and those who prepare and audit them – and where the cost of mistakes is so high for all involved – ticking the boxes is perhaps the only answer. This position has been shared by the International Accounting Standards Board to date.

However, that should change, according to the authors of Principles-based or Rules-based Accounting Standards – a Question of Judgement, a report published by the Institute of Chartered Accountants of Scotland. The report argues that global convergence of accounting standards cannot be achieved by a rules-driven approach. The argument for principles, not rules, is that rules-based accounting adds complexity, encou-rages financial engineering and does not necessarily lead to ‘a true and fair view’, nor ‘a fair presentation’.

To achieve the goal of principles-based standard setting would require a radical change in the global profession so that preparers and auditors of accounts assume more responsibility for making judgements and seek less detailed guidance from standard setters and regulators.

Detailed matters should be left to the judgement of preparers and auditors with clear disclosure of how that judgement has been exercised. This may make theoretical sense but would require a bonfire of accoun-ting vanities. Vested interests are too entrenched. Standard-setters complain they are criticised because they produce rules-based standards, but claim they do so only because they are asked to answer questions from accounting experts at corporates.

Over the decades, the willingness of auditors to hold in check their clients through the exercise of good professional judgement is unclear. The amount that auditors and finance directors disagree is still one of the great secrets in corporate governance and corporate reporting.

While the pros and cons of principles versus rules have most impact on standards setters, preparers and auditors, it will inevitably have an impact on users of financial information. One key objective of financial reporting is ‘comparability’, which usually means identical accounting treatment for all transactions of a defined class. But some argue that comparability allows users of accounting information to understand the economic reality of the transaction.

A move towards principles could see the need for a shift in understanding of comparability. This would potentially give finance directors more freedom. The ‘principles versus rules’ accounting debate sparked into life occasionally by corporate scandals or the emergence of a new accounting standard-setting regime could evolve into a question of: “Who makes the judgement, who sets the principles? If it’s me, great; if it’s you, I’d be a lot less keen.”