Question

What are the advantages and disadvantages of a rules-based approach, for example, FASB ASC 840-30 (formerly FAS 13) on capitalization of leases and a principles-based approach, such as IAS 17 accounting for leases?

Answer 1

While US GAAP is often considered rules based, it is better to think about individual standards within US GAAP as being more or less rules-based. There are advantages and disadvantages to a rules based approach.

Advantages :

include clarity in application, reduction of risk (but only when the applicable rule is followed), and comparability for companies in the same industry for the same rule.

Disadvantages :

include a regimented approach where a transaction must be accounted for in accordance with the rule even if the applied accounting is misleading, non-comparability between different industries when the transactions are similar, and increased risk when the applicable rule is not followed (its hard to defend a position when the rule is broken).

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.