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A key concern arising from the recent business scandals is that U.S. accounting standards have become "rules-based," filled with specific details in an attempt to address as many potential contingencies as possible. This has made standards longer and more complex, and has led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavorable reporting. In addition, the quest for brightline accounting rules has shifted the goal of professional judgment from consideration of the best accounting treatment to concern for parsing the letter of the rule.
To address these concerns, the Sarbanes-Oxley Act of 2002 required the SEC to examine the feasibility of a principles-based accounting system. The SEC rendered an interesting study that focuses on "objective-oriented" standards (www.sec.gov/news/studies.shtml). Accounting firm leaders have supported a move toward principles-based standards. Sam DiPiazza, CEO of PricewaterhouseCoopers, and Ed Nusbaum, CEO of Grant Thornton, have both publicly proposed a switch to principles-based standards. The Financial Accounting Standards Committee (FASC) of the American Accounting Association believes that a principles-based approach is more likely to result in transactions that reflect their true economic substance. Finally, FASB Chair Robert Herz has said that the current rules-based system is problematic because "those who want to comply with rules ... are not always sure of everything they need to look at. Those looking to get around the rule ... can use legalistic approaches to try and do it" (Business Week online, 2002).
Despite all of this discussion, a precise definition of principles-based accounting remains elusive. What follows is a proposed definition and an explanation of how standards developed aceording to this definition would differ from the current system. The usefulness of the definition is demonstrated by a comparison of U.S. Generally Accepted Accounting Principles (GAAP) and International Accounting Standards (IAS) regarding the treatment of leases. Principles-based accounting has advantages and disadvantages, which should be weighed in the context of FASBproposed movement toward principles-based accounting.
Principles-Based versus Rules-Based Accounting
Simply stated, principles-based accounting provides a conceptual basis for accountants to follow instead of a list of detailed rules.
In a 2002 presentation to the Financial Executives International, Robert Herz, Chairman of FASB, explained it as follows:
Under a principles-based approach, one starts with laying out the key objectives of good...