Question

The old GAAP hierarchy is said to be a rules-based approach, and the new codification is meant to move our standards to a principles-based approach. what is the interpretation of the distinction between these two philosophies?

Answer 1

Rules-based accounting such as generally accepted accounting principles (GAAP) is used as a conceptual basis for accountants. A simple set of key objectives are set out to ensure good reporting. Common examples are provided as guidance and explain the objectives. Although some rules are unavoidable, the guidelines or rules set are not meant to be used for every situation. The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes compel managers to manipulate the statements to fit what is compulsory. The problem with principles-based guidelines is that lack of guidelines can produce unreliable and inconsistent information that makes it difficult to compare one organization to another.

When contemplating which accounting method is best, it must be made certain that the information provided in the financial statements is relevant, reliable and comparable across reporting periods and entities. Increased discussion has pushed accountants towards principle-based accounting, but it is recognized that the method needs to be modified to make it more effective and efficient.

The companies and firm are always required to prepare financial statements in compliance with the standards set by the Financial Accounting Standards Board (FASB), the standards of which are generally principles-based. These days are witnessing a lot of debates over whether principles-based accounting is more efficient than the popular rules-based accounting, particularly in responding to accounting scandals like Enron and WorldCom.
In fact, rules-based accounting is fundamentally a list of detailed regulations for accountants to follow in preparation of financial statements. Many accountants are in favour of the prospect of employing the rules-based standards because they can be, in the absence of rules, brought to the court of law should their judgment of the financial statements be incorrect. When there are strict rules to abide by, the possibility of being sued is reduced. Establishment of a set of rules can promote accuracy, thereby reducing ambiguity and/or equivocality, which can cause aggressive reporting decisions by management. On the other hand, the complexity of rules can create undesirable confusions in the preparation of financial statements.
As for principles-based accounting, like generally accepted accounting principles (GAAP), a simple set of key objectives are established to ensure good reporting upon the part of the accountants. GAAP is employed by the accountants on a conceptual basis. Common examples are provided as guidance and the objectives are explained. Despite certain rules being unavoidable, the guidelines or rules are not meant to be applied to all situations. The basic advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes force managers to manipulate the statements to fit what is compulsory. The problem with principles-based guidelines is that lack of guidelines can yield unreliable and inconsistent information, which makes it difficult to compare one organization to another.
This being so, when contemplating which accounting method is better, it must be made sure that the information provided in the financial statements is relevant, reliable and comparable across reporting periods and entities. Increased discussion has pushed accountants towards principles-based accounting, but it is recognised that the method needs to be modified to make it more effective and efficient.