The question whether accounting standards should be principles or rules-based has been debated for decades. Views are often influenced by historical tradition, legal and regulatory environments and prejudice. However, with IFRS in the process of becoming the accepted global financial reporting framework, and with the growing emphasis on convergence between US GAAP and IFRS, this debate is once again at the forefront of the standard-setting agenda.
The distinction between the two approaches lies precisely where their respective descriptions suggest: principles-based standards are based on a clear hierarchy of overarching principles, contain few or no 'bright line' provisions and rely heavily on the exercise of judgement as to what constitutes fair presentation; rules-based standards are characterised by 'bright line' and anti-abuse provisions and allow relatively less scope for the exercise of judgement in their application. An example of this distinction lies in the requirements for lease classification under IFRS and US GAAP respectively, in so far as IFRS requires a judgement to be formed as to where the risks and rewards incidental to ownership of an asset lie, whereas US GAAP sets down a checklist of rules that must be applied in making this determination. This is not to say that IFRS does not also have rules-based standards, since IAS 39 – Financial Instruments: Recognition and Measurement and IFRS 2 – Share-based Payment – are highly rules-based and not to say that US GAAP does not contain principles.
In fact, IAS 39 provides an instructive example of the differences between rules and principles.i In accounting for the hedging of financial risk, a guiding principle might be that the performance statement should reflect the reduction of volatility achieved economically by the hedge. Intuitively, if a company has mitigated the effects of a particular risk – foreign exchange fluctuations for example – it makes sense that this reduction in volatility should flow through to the performance statement in the form of a neutral profit and loss impact (or something which is close to neutral depending on the efficacy of the hedge). It is interesting to note that IAS 39 does not embody such a principle. Rather, there are complex rules that determine whether or not it is acceptable to flow the impact of the hedge and hedged item through profit or loss in the same period; and, because the rules include onerous documentation and effectiveness testing requirements, profit and loss neutrality is an outcome that is effectively optional. In other words, if the hedge is not documented and/or the effectiveness tests are not performed, hedge accounting cannot be applied. As a result, it is perfectly possible for the performance statement to report volatility even though economically none exists because a company is hedged perfectly over the term of the hedged instrument.
Whether or not IFRS develops into a truly principles-based system will depend largely on the attitudes and approaches of all the participants in the financial reporting process including standard-setters, preparers, auditors, users and regulators. Whilst US GAAP is clearly principles-based (though not based on the same principles throughout, which creates its own problems), it seems that the rules have grown over a number of years due to the demands of preparers and auditors for more detailed guidance and certainty, and the demands from regulators for consistency. There seems, therefore, to be a natural tension between the desire for comparability and the quest for a principles-based systemii, and it is essential that IFRS does not suffer the growth of rules as US GAAP has. In our view, it is necessary to recognise that complete comparability is never possible in accounting. Instead, more emphasis needs to be placed on explaining the key judgements made by preparers of financial statements, including the sensitivities around those judgements. However, the danger for IFRS is that the demand for implementation guidance may increase as IFRSs become more widely applied and more detailed rules are called for.
Extract from International GAAP (r) 2010
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- This example is taken from The Institute of Chartered Accountants of Scotland, 'Rules Not Principles – A Question of Judgement', page 6.
- A view expressed also by The Institute of Chartered Accountants of Scotland in 'Rules Not Principles – A Question of Judgement', page 5.
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