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Principles-Based Standards in Accounting: Arguments Against Their Advantages Over Rules-Based Standards

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Abstract

The Sarbanes-Oxley Act required the U.S. Securities and Exchange Commission (SEC) to study the potential effects of shifting U.S. Generally Accepted Accounting Principles (GAAP) to be less rules-based and more principles-based and the FASB proposed changes designed to move in that direction (FASB 2002). These developments, along with a desire to converge U.S. GAAP with International Financial Reporting Standards (IFRS), which is purportedly a principles-based system, motivate this paper, which considers whether such systems in fact offer advantages over rules-based standards. In addition to the accounting rules themselves, this push for principles based standards has expanded to include other governance issues, such as the evaluation of internal controls (see, for example, the COSO Exposure Draft (COSO 2011). This paper will argue that in such policy cases, attempts to establish a principles-based approach might result in delineating a set of attributes derived from specific principles that then become criteria for an assessment that is, or closely resembles, rule-making.
Principles-Based Standards in Accounting:
Arguments Against Their Advantages Over Rules-Based Standards
Gary P. Schneider, William S. Perlroth Professor of Accounting, Quinnipiac University
ABSTRACT
The Sarbanes-Oxley Act required the U.S. Securities and Exchange Commission (SEC) to study the
potential effects of shifting U.S. Generally Accepted Accounting Principles (GAAP) to be less rules-
based and more principles-based and the FASB proposed changes designed to move in that direction
(FASB 2002). These developments, along with a desire to converge U.S. GAAP with International
Financial Reporting Standards (IFRS), which is purportedly a principles-based system, motivate this
paper, which considers whether such systems in fact offer advantages over rules-based standards. In
addition to the accounting rules themselves, this push for principles based standards has expanded to
include other governance issues, such as the evaluation of internal controls (see, for example, the COSO
Exposure Draft (COSO 2011). This paper will argue that in such policy cases, attempts to establish a
principles-based approach might result in delineating a set of attributes derived from specific principles
that then become criteria for an assessment that is, or closely resembles, rule-making.
A substantial body of research exists on how to determine whether a specific regulatory regime is
principles-based or rules-based, and which approach is most appropriate to use in a particular setting (e.g.
Bentson et al. 2006; Black 2010; Cunningham 2007; Ford 2008, 2010; Kershaw 2005; Ojo 2010, 2011;
and Schwarcz 2009). This paper will argue that policy-making bodies in accounting and corporate
governance have not considered this research, which developed from studies of various general business
and financial industry regulatory regimes on both sides of the Atlantic. Although drawing clear and
determinative conclusions from such a wide range of inquiry is difficult, some general guidance is
available in this research to help policy-makers and accounting standard-setters evaluate whether a shift
toward a principles-based approach is advisable. One general finding is that few, if any, examples of pure
rules-based or principles-based regulatory regimes exist. Black (2010) and Ford (2008, 2010) argue
virtually all such guidelines and regulations are a mixture of both approaches.
Bentson et al. (2006), in evaluating Financial Accounting Standards Board (FASB) rules-based standards,
note the format of the standards and their contents are interdependent. That is, an accounting principle
that requires substantial judgment will also require significant guidance and even exceptions; this can
result in a principle that operates very much as a set of rules. Bentson et al. (2006) conclude the
international move toward principles-based accounting standards might be doomed to end in a regime that
is called principles-based but, in fact, operates much as a rules-based regime would. Cunningham (2007)
has a more cynical take on essentially the same outcome. His assessment is using the term “principles-
based” is misleading because construction of such regulatory schemes is impossible. He concludes
regulatory schemes are labeled “principles-based” in an intentionally misleading rhetoric.
Schwarcz (2009) identifies an interesting paradox in the implementation of principles-based regulatory
schemes. He notes unless an organization subject to a principles-based regime is protected from liability,
it will act as if subject to a rule, perhaps even an unintended rule. Since organizations subject to GAAP
and related corporate governance standards are not insulated from liability, this research suggests an
unintended consequence of using a principles-based approach could be that organizations infer
inappropriate rules and then follow them.
Black (2010) proposes a taxonomy of principles-based regulation that includes two dimensions, formal-
substantive and dyadic-polycentric. Specifically, formal systems exist when principles are accompanied
by significant guidance, written explanations, and rules. Formal systems are usually characterized by
relatively weak regulators. In more substantive systems, relatively more powerful regulators make
subjective judgments using more abstract criteria. The second dimension distinguishes dyadic regimes,
which have one strong regulator dealing with a specific class of regulated agents or activities, and
polycentric regimes, that include multiple regulators who are responsible to multiple stakeholders. These
regulators oversee agents or activities that are relatively more heterogeneous. This paper will argue that
accounting standards (such as GAAP) and corporate governance standards (such as the evaluation of
internal control and determinations regarding its effectiveness) are likely polycentric in Black’s (2010)
second dimension because multiple regulators exist. For example, the network of stakeholders with
concerns about internal control would include the organization’s managers, its internal audit staff, and its
independent auditors. These parties function as participants in the evaluation and determination activities.
Regulators in this regime include standard-setters such as the SEC and other government agencies along
with guidance-creators such as the Committee of Sponsoring Organizations (COSO) and the IT
Governance Institute (ITGI). It is not clear whether the first dimension is, or should be, formal or
substantive. These factors enter into any determination of whether a principles-based regime is the most
appropriate for a given complex regulatory setting.
REFERENCES
Bentson, G. J., M. Bromwich, and A. Wagenhofer. 2006. Principles- versus rules-based accounting
standards: The FASB’s standard setting strategy. ABACUS 42 (2): 165188.
Black, J. 2010. The rise, fall and fate of principles based regulation. Working paper, London School of
Economics.
Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2011. Internal Control
Integrated Framework. Available at: http://www.coso.org/ic-integratedframework-summary.htm.
Cunningham, L. A. 2007. A prescription to retire the rhetoric of “principles-based systems” in Corporate
law, securities regulation, and accounting. Vanderbilt Law Review 60 (5): 14091493.
Financial Accounting Standards Board (FASB). 2002. Proposal: Principles-Based Approach to U.S.
Standard Setting. File Reference No. 1125-001. Norwalk, CT: FASB
Ford, C. 2008. New governance, compliance, and principles-based securities regulation. American
Business Law Journal 45 (1): 160.
Ford, C. 2010. Principles-based securities regulation in the wake of the global financial crisis. McGill
Law Journal 55 (2): 257307.
Kershaw, D. 2005. Evading Enron: Taking principles too seriously in accounting regulation. Modern Law
Review 68 (4): 594625.
Ojo, M. 2010. International framework for liquidity risk measurement, standards and monitoring,
corporate governance and internal controls. Bank for International Settlements Publications.
April 6. Available at: http://ssrn.com/abstract=1584402.
Ojo, M. 2011. Building on the trust of management: Overcoming the paradoxes of principles based
regulation. Banking & Financial Services Policy Report 30 (7): 19.
Schwarcz, S. L. 2009. The “principles” paradox. European Business Organization Law Review 10: 175
184.
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