Are we paying enough attention to principles?

The complexity of financial reporting has caused concern in recent years and prompted more people to join the debate about the benefits of principles over a rules-based system of accounting.

It is easy to repeat the mantra that principles are good and rules are bad. But in reality neither a purely rules-based nor a purely principles-based system has ever existed. Each accounting standard sits on a spectrum between rules and principles. Many commentators argue that, today, we are too skewed towards the rules-based end of the spectrum and the focus for standard setters should be on pushing the pendulum towards more principles-based standards and a greater use of judgement.

As a contribution to the debate, the large accounting firms published a white paper ‘Principles-based accounting standards’ to coincide with the Global Public Policy Symposium hosted by the firms in New York last month. The paper proposes a framework to use in developing principles-based standards and suggests changes needed on the part of participants in the financial reporting process to support such a system.

The white paper proposes six characteristics that the firms believe are the key elements of a high-quality, principles-based accounting standard: 

1. Faithful presentation of economic reality
2. Responsive to users' needs for clarity and transparency
3. Consistent with a clear Conceptual Framework
4. Based on an appropriately-defined scope that addresses a broad area of accounting
5. Written in clear, concise and plain language
6. Allows for the use of reasonable judgement.

While each of the six characteristics is fundamental to the success of any principles-based system, the first two are regarded as pre-eminent. The need for them should be self-evident. Indeed, the whole purpose of requiring companies to publish audited financial statements is to provide investors with a tool to gauge economic and management performance and prospects. Yet the reality is that under today’s accounting this goal is often not met. Companies can comply with the strict letter of the requirements, yet may fail to provide the information that provides a clear picture of their results or financial position.

In the UK, some fourteen years ago, the Accounting Standards Boards issued a standard by the name of FRS 5, Reporting the substance of transactions. As its name suggests, the objective of this standard is to ensure that the substance of an entity’s transactions is reported in its financial statements. This basic principle of ‘substance over form’ is also enshrined in the IASB’s Framework for the preparation and presentation of financial statements, so what is so different about the UK standard? Arguably nothing, but the status of FRS 5 as an accounting standard in the UK does seem to have had an impact on the mindset of financial statement preparers and other participants in the financial reporting process.

The IASB is working on updating its Framework, but is also pressing ahead with other important projects in parallel. In other words, there does not seem to be too much concern about details of particular standards being finalised before there is agreement on the underlying principles.

What do you think about this approach? How should the IASB go about determining its priorities for the future? Are the projects on the current agenda so important that progress needs to be made urgently? Or is insufficient attention being paid to agreeing the principles in the Framework? Should the IASB develop a standard dealing specifically with reporting the substance of transactions, rather like the UK’s FRS 5? 

As always, I would be interested in your views either by commenting here or by email.

Comments

Principles-based accounting is a worthwhile goal, but I have serious reservations as to whether it can be achieved in the long-term. Both companies and thier independent auditors are looking for as much certainty as possible, and as a result, are constantly asking for more clarification.

There is currently a lot of excitement in the US about moving towards IFRS because it has less rules. My concern though is that as IFRS matures and the IASB has more time to write various rules in response to issues being raised, IFRS will start to migrate towards a rules-based standard similar to existing US GAAP. For example, the recently issued FAS 141R [the revised business combinations standard] is one of the more complicated standards issued and it was a joint effort of the FASB and the IASB.

Thus, let's hope I am wrong on all accounts.

[Richard Keys]

It's a very good point. And yes, I hope you are wrong too! Moving to a more principles-based approach will be demanding and, for many, it is an uncomfortable place to go particularly in litigious environments in which comfort is taken from being able to show compliance with rules and 'bright lines'. To succeed, the current mindset of company management, auditors, regulators, the courts and the law among others will have to evolve and change. But I still believe it is a goal worth aiming for. The alternative we know is not attractive.

Richard