Principal vs Rule Based Accounting

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An Insight on IFRS versus U.S GAAP & Implications of IFRS adoption on Financial Statement and Accounting Quality

Q2) Principle and rule-based accounting reflect different approaches to accounting. The pros and cons of rule-based accounting (RBA) and principle-based accounting (PBA) are as discussed. (1) RBA deters creative accounting as rules reduce opportunistic discretion unlike PBA which is more subjective and ambiguous.On the other hand, others argue that rules are a means to circumvent the objectives of a standard and more vulnerable to transaction restructuring. Principles leave less room for preparers to justify “inappropriate” interpretations of standards, thereby reducing creative accounting. (2) The complicated accounting rules used under RBA is too onerous, creating problems for users, preparers and setters alike. In seeking compliance with rules, users tend to lose focus on the spirit of the standard and objectives of fair presentation. Principles are simpler, focused on objectives and hence user-friendly to the masses. (3) It is said that rules provide greater comparability due to application of consistent rules on events and transactions. Furthermore, Sunder’s article argues that IFRS’s principle-based approach introduces more judgement, “giving rise to greater variability in application than a more detailed rule”. However, comparability can be enhanced under PBA if more disclosures are made on key judgements made. (4) Due to its authoritative and prescriptive nature, rule-based standards lower ambiguity and hence, tend to lower litigation risks for auditors and preparers. PBA involves greater judgement and discretion, hence increasing their exposure to litigation risk. Increased documentation may mitigate such risks though. (5) RBA is desired by preparers and auditors as it provides detailed guidance and ‘black-and-white’ solutions to ambiguous issues. This results in deterioration of quality of the accounting profession. Conversely, PBA requires professionals to exercise judgement and take personal responsibility. This promotes cultivation of skilled professionals essential to the development of the accounting industry. (6) RBA standards are not comprehensive as no amount of rules can detail all possible scenarios. Furthermore, it is static relative to industry changes. In contrast, PBA is comprehensive and flexible enough to handle new problems in this dynamic environment. Q3) Overarching importance is placed on the decision usefulness of financial statements, as stated by the objectives of reporting standards. Decision usefulness in turn is determined by the qualitative characteristics of relevance and reliability.

Relevance is defined as “information capable of making a difference in users’ decisions. It must be noted that information relevant for decision-making differs amongst stakeholders. Firm owners may require information for stewardship purposes whilst investors may want information predicting a firm’s future cashflows for valuation purposes. This results in stakeholders having different preferences for types of measurement and accounting standards, which the IFRS may or may not fulfil. However, in light that financial statements are designed mainly to meet the needs of external users not privy to internal information, i.e. the investors and creditors mainly, relevance has generally been elevated with the use of IFRS. For e.g. IFRS has seen improvements in aspects like off-balance sheet items, segment reporting and consolidation. Cash items are more visible as compared to the past and there is greater balance sheet transparency as desired by investors. This is in line with the trend of the marketing moving towards use of current value computations relative to less savvy value measures such as P/E ratios. IFRS has resulted in greater disclosures being made and hence much more information being included in the financial statements today, in particular, the notes to financial statements....
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