The parade of corporate accounting scandals of the last decade, with lion’s share occurring in 2002, has developed deep antipathy and distrust towards corporations and their reporting practices, and casted doubts on the opinions of audit firms. As majority of these accounting frauds occurred in the US (See Appendix), there was a widely-held view that rules-based accounting standards have allowed failure of large corporations like Enron and World Com, since US GAAP is perceived to emphasize on the rules-based approach to standards setting. This in its turn has put enormous pressure towards the US regulators and standard setters to relook into roots of accounting standards to regain public confidence and investor trust in the financial markets (Lev, 2012).
The first major regulatory response was Sarbanes-Oxley Act of 2002 (Sarbox), which sparked a hot debate between rules-based versus principles-based accounting standard supporters. In this paper, we shall distinguish between these approaches and provide synthesis of arguments supporting each approach from the existing literature. Based on these explanations, we conclude that choice between rules and principles based approach can be difficult, give some view on dual classification of approaches to standard setting.
Defining and Distinguishing Rules and Principles
Although US GAAP are generally considered to be rules-based and International Financial Reporting Standards are claimed to be based on principles and require professional judgment (Schipper, 2003), the distinction between rules-based and principles-based standards is not well defined and can be variedly interpreted (Bennett et al, 2006). The clarifications on the meaning of rules and principles and their dissimilar features can be found in the legal and accounting literature. The definitions in the legal literature are important stepping stone for more complex and industry-specific definitions in the internal realm of accounting research.
Generally speaking, legal scholars distinguish rules and principles in accordance with degree of specificity and level of judgment required (Wüstemann and Wüstemann, 2010). For example, Braithwaite (2002) argues that principles are vague prescriptions and rules are specific prescriptions. Similarly, Cunningham (2007) asserts that principles are vague as they provide negligible ex-ante guidance, whereas, rules are very specific as the offer more a priori guidance. He also claims that principles require decision maker to use judgment when applying them, whilst, rules leave almost no room for judgment.
Accounting literature is generally in conformity with the definitions provided in the legal literature: many accounting scholars as well as regulators describe rules as being very detailed that they clearly list exact accounting treatments for specific transactions or events. Principles are characterized as general guidelines that call for judgment with respect to the accounting issue at hand rather than providing details of how these guidelines should be implemented (Psaros, 2007).
Although accounting literature agrees with definitions provided by legal scholars, there are some internal industry-specific considerations as well. For example, some researchers note that accounting rules contain quantitative borderlines (often referred to as “bright-lines” in accounting literature), exceptions and sometimes inconsistencies. Others claim that principles are originated from full and consistent conceptual framework (Bonham et al., 2009). If we consider these additional definitions in terms of legal literature, we can see rules do not necessarily contain quantitative thresholds, exceptions and inconsistencies, and can be also be derived from a full and internally consistent array of high-level objectives (Wüstemann and Wüstemann, 2010).
Such additional definitions represent mere reflection of deficiencies in the U.S. standards, which have become so...