PrinciplesBased Accounting Standards

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Principles-Based Accounting Standards

• Jennifer Morin
• Anna Hough

Article by Katherine Schipper, FASBAccounting
Horizons, March 2003
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Article Overview

• Rules based
• -current system
• -detailed
• -loop holes
• Principles based
• -less detail
• -overall picture
• -professional judgment

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Introduction

• Sarbanes Oxley, Section 108
• SEC to conduct study of adoption of
  principle-based accounting system.
• - What extent of principles based system
  already exists?
• - How much time would be required to change the
  system?
• - Is the change feasible?
• - What would be the economic impact of the
  change?

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Two Themes

• Current System- allegedly rules-based
• -some consider it inappropriate
• - check-box mentality
• Principles-based system
• - requires appropriate exercise of professional
  judgment

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Is U.S. Financial Reporting Based on Principles?

• Examples of the Use of Principles in Setting
  Accounting Standards
• Business Combinations
• - Purchase accounting
• - Pooling-of-interests
• Measuring Financial Instruments at Fair Values
• - Scope
• - Definitions
• -ex 22 Derivatives Implementation Group
  Issues

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Why are U.S. Financial Reporting Standards
Viewed as Rules-Based?

• Scope Exceptions
• Allows to exclude a group of similar items to
  avoid a conflict with another standard
• Treatment Exceptions
• Allows to treat a group of similar items
  differently to reduce income fluctuations
• Reduces comparability
• Detailed Implementation

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Some Effects of Detailed Implementation Guidance

• Increased Comparability
• Includes numerical examples
• Increased Verifiability
• Agreement of measurements
• Enforcement and Litigation
• Assists preparers, auditors, regulators,
  litigators

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Detailed Implementation Guidance (cont.)

• Opportunities for Earnings Management
• Creates a Bright-Line
• Reduces relevance, reliability, and/or
  comparability

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Some Additional Considerations in a Discussion
of Principle-Based Standards

• Preparer and Auditor Expertise
• More training and education
• Volatility of Reported Income
• Eliminates scope exceptions and treatment
  exceptions
• Inconsistancies in Financial Reporting
• Change accounting policies

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Additional Considerations (cont.)

• Transition
• Retroactive application
• Prospective application
• Cumulative effects approach
• Interactions between Principles-Based Financial
  Reporting Standards and Corporate Governance
• Sarbanes-Oxley

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Conclusion

• Standards are based on principles, but appear to
  be rules-based.
• If detailed implementation guidance is removed,
  comparability may suffer.
• Behavior may change when removing exceptions and
  detailed guidance

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Questions? Comments?