Question

Here is the heart of the debate between GAAP and IFRS:

Describe the difference between rules-based and principles-based financial statements. Which do you think is better?

Answer 1

Soluton

Rules-based accounting is basically a list of detailed rules to be followed when preparing financial statements. Many accountants favor the prospect of applying rules-based standards because, in the absence of rules, they could be brought before the court if their judgments in the financial statements were incorrect. When there are strict rules that need to be followed, the possibility of legal action is diminished. Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive management reporting decisions. However, the complexity of the rules may lead to unnecessary complexity in the preparation of the financial statements.

Principle based accounting which involves accounting principles such as the Generally Accepted Accounting Principles (GAAP) are used as a conceptual basis for accountants. A simple set of key objectives is set to ensure good reporting. Common examples are provided as guidance and the objectives are explained. Although some rules are unavoidable, the guidelines or rules laid down are not intended to be applied to every situation. The fundamental advantage of principle-based accounting is that its broad guidelines can be practical in a variety of circumstances. Precise requirements may sometimes force managers to manipulate statements in order to adjust to what is mandatory. The problem with guiding principles is that the lack of guidance can produce unreliable and inconsistent information that makes it difficult to compare one organization to another.

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

A significant benefit of principled based financial statements can be shown in its broad guidelines, which can be applied to different situations. Broad principles may avoid drawbacks associated with specific requirements that allow certain contracts to be prepared specifically to manipulate their purpose. Evidence has been found in a previous study by FASB that, in order to avoid the acquisition of additional liabilities, the managements intentionally tend to structure leases as operating leases. The provision of broad guidelines could therefore improve the representational accuracy of the financial statements.

In addition, principles-based financial statements allow accountants to use their professional judgment to assess the substance of transactions. This approach significantly differs from the underlying "box-ticking" approach which is common in the rules-based accounting standards. The professionalism of financial statements could also be improved by using professional judgment rather than relying on comprehensive rules.