Advantages and Disadvantages of Principles-Based Accounting

What are the advantages and disadvantages of principles-based accounting? Perhaps the primary benefit of principles-based accounting rests in its broad guidelines that can be applied to numerous situations. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent. A 1981 study sponsored by FASB found evidence that managers purposefully try to structure leases as operating leases to avoid incurring additional liabilities. Providing broad guidelines may improve the representational faithfulness of financial statements. In addition, principles-based accounting standards allow accountants to apply professional judgment in assessing the substance of a transaction.

This approach is substantially different from the underlying “box-ticking” approach common in rules-based accounting standards. FASB Chair Robert Herz has stated that he believes the professionalism of financial statements would be enhanced if accountants are required to utilize their judgment instead of relying on detailed rules. Another advantage of a principles-based system is that it would result in simpler standards. Herz has claimed that a principles-based system would lead to standards that would be less than 12 pages long, instead of over 100 pages (BusinessWeek online, 2002). Principles would be easier to comprehend and apply to a broad range of transactions.

Harvey Pitt, former SEC chairman, explained this as follows: “Because standards are developed based on rules … they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent.” Finally, the use of principles-based accounting standards may provide accounting statements that more accurately reflect a company’s actual performance because, as Australian Securities and Investments Commission Chair David Knott has stated, an increase in principles-based accounting standards would reduce manipulations of the rules (Nationwide News, 2002).

Conversely, there are potential drawbacks to a principles-based approach to standards setting. A lack of precise guidelines could create inconsistencies in the application of standards across organizations. For example, companies are required to recognize both an expense and a liability for a contingent liability that is probable and estimable. On the other hand, a contingent liability that is reasonably possible is only reported in the footnotes. With no precise guidelines, how should companies determine if liabilities are probable or only reasonably possible? The lack of bright-light standards may reduce comparability and consistency, a primary precept of financial accounting.

Many accountants seem to prefer rules-based standards, possibly because of their concerns about the potential of litigation over their exercise of judgment in the absence of bright-line rules. The number of requests for implementation guidance received by FASB has always been high, and their significance resulted in the formation of the Emerging Issues Task Force. If financial statements conform with accepted rules, the bases for a lawsuit are diminished.