Hull University Business School 20112011

Advanced Financial Reporting and Theory

Course Assignment: Principle-Based Accounting

Student Name: So Min Po

Class B

Background of study Enron Corporation, one of the world's leading electricity, natural gas, communications, and pulp and paper companies, at the end of 2001, it was revealed that its reported financial condition was sustained substantially by institutionalized, systematic, and creatively planned accounting fraud and eventually lead to bankrupt.

Such case is one of the famous business scandals in U.S.; this scandal creates a strike on current accounting standards. The key concern arising from here 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, the current way of accounting has been under a great deal of criticism. Therefore, there are many debates on whether necessary to shift the rule-based to principle-based.

Criticism of Rule-base accounting

Rules-based accounting is basically a list of detailed rules that must be followed when preparing financial statements The SEC (2003, p. 23), indicates that the primary characteristics of rules-based standards are the existence of exceptions and brightlines which lead to very detailed implementation guidance. The rules had been set very clear by the setter, black and white are very distinct, and you should no doubt to follow such rules in such situation. However, there are pros and cons for rule-base accounting

Advantages:
Rule-based

standards are generally considered easier to audit for compliance

purposes, and may produce more consistent and comparable financial reports across entities.
Having

a set of rules can increase accuracy and reduce the ambiguity that can

trigger aggressive reporting decisions by management.

Disadvantages:
May

include a lack of flexibility with regard to changing conditions and new

products, hence requiring almost continual maintenance at times.

Lead

accounting standards that are both more detailed and more complex than

principles-based standards (Nelson 2003)

Criticism of principle-based accounting

Principle-based accounting is used as a conceptual basis for accountants. A simple set of key objectives are set out to ensure good reporting. Common examples are provided as guidance and explain the objectives. However, it is allow standard user to make reasonable judgment. Advantages:
Principles-based

accounting rests in its broad guidelines that can be applied to

numerous situations. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent.

Principles-based

accounting standards allow accountants to apply professional

judgment in assessing the substance of a transaction.

Another

advantage of a principles-based system is that it would result in simpler

standards and avoids a large number of rule.

Disadvantages:
To

the extent that they rely on individual judgment to interpret and implement the

standards, there is a danger that they can be used to manipulate financial results.

 More

difficult to audit relative to compliance, and concern over consistent and

reliable interpretations across entities. Each company could determine its own unique way to apply accounting standards, and you would have no assurance of consistency Since Principle and Rule-based standard have their competitive advantage and disadvantage. Important question is whether a standard should attempt to describe precisely the application of the general standard in almost all conceivable cases (as is practice in the United States), or whether a standard should be clearer on the principle (with more general guidance on its application) while relying more heavily on building precedents in actual audits (on a case basis). This study will focus on how these two based help the standard setter and shareholder.

As an aid to effective standard setting

Create the coherence Objective of Accounting Standards setting is to harmonize and standardize the different diverse accounting standard policies and practices with a view to eliminate to the extent possible the non-comparability of financial statements and the reliability to the financial statements.

For the view of consistence, Jens and Sonja (2010) stated that principles-based standard do not provide a sufficient structure to limit managers judgment in the application of the principles to specific transactions and events. On contrary, rulebased standard can be more guarantees on consistence, since users crave answers for their specific situations by a list of detail rule.

For example, Development costs can be capitalized under IFRS if certain criteria are met for increasing the profit on income statement, so management can choose whether to capitalize such transaction. But it is considered as expenses under U.S. GAAP, thus the management have no choice to deal with such treatment.

However, for the view of standard setter, they need to setup many of rules to cover each situation because if the situation is different from other, they need to create a new for such situation. So there create unnecessary complexity around each specific element of accounting. The problem here is not only for standard user, but also for the user because there are so many rules they need to follow.

Under Principle-based, accounting setter can set the standard that having broadly defined scopes. They only need to setup a limited number of core standard addressing key balance sheet and transaction categories, and then select topic-specific standards illustrating how the core standard are applied to the most typical categories of

transaction. Eventually, allow for the management and auditors applied such core standard in actual practices under reasonable judgment. It share the responsibility for provide a high-quality financial report with the managements and auditors

Consistence can be ensured finally, since they follow the core standard. And management needs to disclosure why these judgments were made (e.g. different tax policy, culture) and how they impact the financial results. Finally, the standard setter can help the user for comparison, since they know the difference of each company and reduce the number of rules.

Increasing the quality of information The standard should help the preparer to prepare a high-quality financial statement The fundamental request of financial statement is to fully reflect the economics substance so that the user can rely on such statement for making decision. However under rule-based standard, it cannot guarantee such request.

For instance, consolidation- under U.S. GAAP if you holding 51% or over of share, you need to do consolidation, but IFRS favors a control model i.e. having a significant influence on a company. The problem is if you holding less than 51% of share, you can choose not to do consolidation for eliminating inter-transaction even you have a significant influence in the management decision. It will be a contradiction with faithful presentation and people cannot rely on such statement.

Under principle-based, it place responsibility for reporting the substance of transactions squarely on management. The management need to convince the auditor why do this treatment, so it help standard setter to enforce them to present a faithful and reliable statement.

As an aid to decision usefulness for stakeholders The goal of stakeholder is hope the company to maximum their wealth. Nevertheless, the transition of principle-based accounting standards which faithfully represent the economics of transaction may cause increased volatility to be reported in earnings since principle-based is a market reality.

For example, the valuation of inventory, under IFRS, LIFO cannot be used rather than use market value i.e. fair value. Under U.S. GAAP, companies have the choice between LIFO and FIFO. In this case, the U.S. approach can provide a more stable valuation of inventory and use the method that maximum the value of inventory. It seems to help to maximum the stakeholder wealth. However, it can reflect the reality of the value of inventory.

Rather than using rule-base to hide such volatility, stakeholders will ultimately be better served by having accesses to clear information about the volatility that actually exists.

Moreover, as a recent debate is stakeholders desire to promote more long-term analysis rather than current obsession with numbers. They hope the financial statement not only reflect the current state of business, but also can be used as a predictive tool. After a investigation on china Yong and Gordian (2009) state that find the principles-based period has more value relevant and informative accounting amounts than do the rules-based regime, also provide evidence that principles-based has more predictive values than rules-based numbers.

Starting in 2005, Hong Kong Financial Reporting Standards (HKFRS) are identical to International Financial Reporting Standards. And all of the December 2003 improvements and new and revised IFRS issued in 2004 and 2005 will take effect in Hong Kong beginning in 2010. So Hong Kong is moving towards principles-based.

Conclusion Under IASB the ultimate objective of financial reporting are provide information for the people who use that information to make economics decisions. And the standard setter should provide guideline/standard to help preparer to achieve such objective. Under principle-based accounting, it shifts the responsibility to management to create a high-quality financial reports rather than standard setter, and reduce the number of rule. It help the user to use such report to make economics decisions.

Nevertheless, the main problem of principles-based is it does not provide a sufficient structure to limit managers judgment in the application of the principles to specific transactions and events.

Thus, accounting regimes should be based on principles, but should not consist of principles only. There should be a set of high-level principles from which more concrete accounting rules are consistently derived. There should take a balance between principle and rule-based accounting.

Reference
ANDREW M. MINTZER, STUART H. HARDEN, Rules vs. principles accounting' , Viewed Jun 2011,standardshttp://findarticles.com/p/articles/mi_m0ICC/is_3_71/ai_91967442/?tag=content;col1 Dain C. Donelson, John McInnis & Richard D. Mergenthaler 2010, Rules-Based Accounting Standards and Litigation, McCombs Research Paper Series No. ACC-06-10. Securities and Exchange Commission. 2003. 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. http://www.sec.gov/news/studies/principlesbasedstand.htm. Jen,W and Sonja,W 2010, Why Consistency of Accounting Standards Matters: A Contribution to the RulesVersus-Principles Debate in Financial Reporting, ABACUS, Vol. 46,. Remi Forgeas 2008, Is IFRS That Different From U.S. GAAP? viewed Jun,2011, <http://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2008/CPA/Dec/USGaap.j sp> Rebecca Toppe Shortridge and Mark Myring, Defining Principles-Based Accounting Standards, viewed Jun 2011 http://www.nysscpa.org/cpajournal/2004/804/essentials/p34.htm Yongtao H, Gordian A. Ndubizu, 2009, Earnings Management and Quality of Accounting Amounts in the Rules and Principles-based Regimes in China, http://www.iasplus.com/resource/0801principlesbased.pdf, viewed on Jun 2011 http://www.fsa.gov.uk/pubs/other/principles.pdf, viewed on Jun 2011-6-26

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