1. Principles of IFRS

2. Overview
The question of whether US GAAP is rules based versus IFRS being principles based is a somewhat ongoing debate that many outside of standard setting do not fully understand. Some have expressed their views as to what principles-based accounting standards should contain and how they should function. However, there has not been much in the way of agreement on the implementation of principles-based standards.
After the Enron collapse and other accounting scandals that came to light in 2001 and 2002, the US Congress had an interest in principles-based accounting standards, the standard-setting process and how accounting standard setting could be improved. With the passage of the Sarbanes-Oxley Act of 2002, the SEC was charged with conducting a study of the US approach to accounting standard setting and the adoption of principles-based accounting standards.

3. Overview
The result of the SEC’s study was a 2003 comprehensive report to Congress on the differences between rules-based standard setting and principles-based standard setting and the recommendations of the SEC as to how accounting standards in the US could be improved.
The name of this report is Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, U.S. Securities and Exchange Commission, July 2003.
This report has been used extensively in developing the content that follows. Additional points have been added that arise from other studies, articles or presentations from around the world.

4. Principles-based standards versus rules-based standards
Characteristics of pure principles-based standards:
Consistent with and derived from a conceptual framework.
Concise explanation of the accounting objective and the integration of the objective into the standard.
Few, if any, exceptions.
No bright-line tests.
An appropriate level of guidance is given to explain the application of the principles.
More reliance is placed on professional judgment to apply the principles.

5. Principles-based standards versus rules-based standards
Characteristics of pure rules-based standards:
The standards may not relate to the conceptual framework but to more specific, prescriptive rules.
Excessive exceptions on the scope.
Inconsistencies between standards.
Detailed, interpretive guidance to address the application for every possible transaction.
Little to no reliance on professional judgment to apply principles.

6. Principles-based standards versus rules-based standards
Difficulties associated with pure principles-based standards:
Loss of comparability because of management and auditor discretion in the application of the principles.
Greater difficulty in seeking remedies against “bad” actors either through enforcement or litigation.
Concern by preparers and auditors that regulatory agencies might not accept “good faith” judgments.

7. Principles-based standards versus rules-based standards
Difficulties associated with pure rules-based standards:
The rules and bright-line tests lead to inconsistencies in the application of the standards and a lack of comparability between companies.
Financial reporting tends to be seen as an act of compliance as opposed to a means of communicating information.
The complexity does not allow for effective understanding and application of the underlying accounting principle.
The rules can be circumvented and can override the intent of the standard.

8. Objectives-oriented standards
Objectives-oriented standard is a phrase utilized by the SEC to describe a type of standard that lies in between a pure principles-based standard and pure rules-based standard.
Characteristics of objectives-oriented standards:
Based on an improved and consistently applied conceptual framework.
Clearly states the accounting objective.
Provides enough detail and structure so the standard can be implemented on a consistent basis.
Minimizes exceptions to the standard.
Avoids use of bright lines that allow technical compliance but avoid the intent of the standard.

9. US GAAP and IFRS
Although we generally think of US GAAP as more rules based than IFRS, IFRS is not purely principles based and US GAAP is not purely rules based.
US GAAP
Substantially all standards are principles based but may have detailed rules based on implementation issues.1, 2
Some standards are excessively rules based, such as leasing, derivatives, stock-based compensation and derecognition of assets and liabilities.
IFRS
Some standards are principles based.
Some standards are not based on the conceptual framework.
Some standards have excessive rules
1 Katherine Schipper, “Principles-Based Accounting Standards,” Accounting Horizons, Vol. 17, No. 1, 2003, p. 63.
2 Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, section I.F., U.S. Securities and Exchange Commission, July 2003.

10. US GAAP and IFRS
Even when it is possible to classify individual provisions as rules or principles, fairly characterizing entire systems as rules-based or principles based is an essentially impossible task. In addition to examining all the individual .provisions within the system, one would have to account for how they are applied and how they interact. Once those stages of a system are accounted for and the benefits appreciated, it is difficult to conclude that any system of corporate law, securities regulation, or accounting can be rules-based or principles based.3
The SEC study3 suggests that neither a pure principles-based set of standards nor a pure rules-based set of standards is optimal. Rather, it suggests that the optimal type of system is a system based on objectives-oriented standards.
1 Lawrence A. Cunningham, “A Prescription to Retire the Rhetoric of ‘Principles-Based Systems’ in Corporate Law, Securities Regulation, and Accounting,” Vanderbilt Law Review, Volume 60, Pages , 2007.
2 Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, section I.F., U.S. Securities and Exchange Commission, July 2003, Executive Summary.

11. Benefits of moving the US toward objectives-oriented standards
Makes the financial statements easier to understand.
Holds management responsible for reporting the economic substance of transactions and auditors responsible for determining whether management has appropriately done so. Thus, the incentives of the managers and auditors will be more closely aligned with the investors’ needs.
Increases the informativeness of the financial statements (assuming managers and auditors exercise their judgment effectively).
Enhances the quality, consistency and timeliness of standard setting.
Aids in the convergence with IFRS.

12. Benefits of moving the US toward objectives-oriented standards
Enhances comparability unlike rules-based standards which reduce comparability because:
Financial engineering circumvents the economic substance of a transaction.
Rules force unlike transactions into the same accounting treatment.
Transactions on either side of bright lines are treated differently.
Less transparency.
Earnings management due to transaction structuring will most likely be less.1
In an empirical study2 of the association between rules-based standards and earnings management behavior, the study finds that rules-based standards are positively associated with the dollar amount of earnings management.
1 Katherine Schipper, “Principles-Based Accounting Standards,” Accounting Horizons, Vol. 17, No. 1, 2003, p. 68.
2 R. Mergenthaler, Principles-Based versus Rules-Based Standards and Earnings Management, Working Paper, University of Iowa, 2009.

13. Costs of moving the US toward objectives-oriented standards
Increases accounting costs:
Due to a reduction in the implementation guidance:
Expansion of resources to answer questions that will arise from practitioners.
Increase in day-to-day interactions with the SEC staff about filings.
Increase in enforcement defense and restatements.
However, these costs are offset by the costs that were created for financial engineering and costs to interpret complex rules.
Potentially increased insurance costs if carriers believe liability has increased.
A compensation premium placed on accountants with strong judgment skills.

14. Costs of moving the US toward objectives-oriented standards
Litigation could be increased, but is somewhat unclear:
The SEC1 argues that it won’t be increased. This is possibly overstated because if preparers and auditors maintain contemporaneous documentation that demonstrates that they considered the substance of the transaction and had a reasonable approach, then their exposure to litigation may not be increased.
Some argue2 that there is no systematic evidence on the issue of whether detailed guidance has an effect on the incidence or cost of litigation. It would depend upon whether the allegations involve violations of principles. If so, then the presence or absence of detailed guidance is not particularly relevant.
In response to the statement above, a study3 of the impact of rules-based standards on litigation was performed. However, the results provide mixed evidence on the issue.
1 “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System,” section V.G., U.S. Securities and Exchange Commission, July 2003.
2 Katherine Schipper, “Principles-Based Accounting Standards,” Accounting Horizons, Vol. 17, No. 1, 2003, p. 69.
3 Dain Donelson, John McInnis, Richard Mergenthaler, Rules-Based Accounting Standards and Litigation, Working Paper, University of Texas, 2009.

15. Costs of moving the US toward objectives-oriented standards
Comparability could be less under objectives-oriented standards if the extra guidance results in more uniformity.
Transition costs will exist due to the need for more training, quality control and oversight mechanisms.
Loss of verifiability.1
Earnings management due to management judgment issues will most likely be greater.2
1 Katherine Schipper, “Principles-Based Accounting Standards,” Accounting Horizons, Vol. 17, No. 1, 2003, p. 68.
2 Ibid.

16. The issue of judgment
There is a need for judgment under both rules-based standards and principles-based standards. Judgment cannot be eliminated:
Standard setters could not possibly identify and prescribe treatment for the extensive number of all types of business transactions.
Extensive rules do not take advantage of the extensive knowledge managers have about the economic substance of the transaction.

17. The issue of judgment
A shift to less rules-based principles will increase the need for judgment:
“A principle-based standard relies on judgments. Disclosure of the choices made and the rationale for these choices would be essential. If in doubt about how to deal with a particular issue, preparers and auditors should relate back to the core principles. The basis for conclusions (the rationale underlying a particular standard and published with it) should also include, in particular, the question of whether there is only a single view to tackle the economics of the situation. Often there are competing views—is one regarded as more relevant? If so, the reasons for choosing that particular view should be explained in the basis for conclusions and the reasons for rejecting the others clearly outlined.”1
1 Sir David Tweedie, Speech before the Subcommittee on Securities, Insurance and Investment of the United States Senate, Washington, D.C., October 24, 2007, p. 10.

18. The issue of judgment
The shift to objectives-oriented standards will require preparers, auditors and regulators to modify their behavior.
Preparers will have to stop the “show me where it says that” mentality.
Auditors will need to move away from the checklist approach.
Auditors and preparers will need to be trained to understand the substance of transactions.
“The Board believes that it may take several years or more for such attitudes and behavioral changes to take root. One reason for that belief is that preparers continue to request scope exceptions, scope exemptions, and treatment alternatives and to oppose changes that would eliminate existing scope exceptions and treatment alternatives. In addition, the Board’s recent experience suggests that many preparers and auditors have become less willing to exercise professional judgment in areas involving accounting estimates, uncertainties, and inherent subjectivity. Instead, they have been requesting detailed rules and bright lines in an apparent effort to reduce the need for the exercise of judgment in inherently subjective areas. Increased accountability for the accuracy of financial information under the new requirements related to the Sarbanes-Oxley Act coupled with a fear of ‘second guessing’ by enforcement agencies and the trial bar are frequently cited as reasons for this behavior.”1
1 FASB Response to the SEC Study on the Adoption of a Principles-Based Accounting System, Financial Accounting Standards Board, July 2004, p. 6-7.

19. The issue of judgment
Regulators will also need to modify their behavior:
“Preparers and auditors would, therefore, need the courage to exercise and defend their judgments in this simplified accounting world. Users and regulators would need the wisdom to accept that there may be more than one answer and over time all parties would have to build the trust that this state of the world implies.”1
1 Principles not Rules: A Question of Judgement, Institute of Chartered Accountants of Scotland, 2006, p. 1.

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