Rule versus principle: BL

Both rule-based and principle-based accounting have their protagonists. The debate on which is better will
be put to rest when the US GAAP converges with IFRS eventually and becomes principle-based.



Students of accounting would be well aware of the long discussed differences between rule-based
accounting and principle-based accounting. Both have their protagonists. While the US GAAP is rule-based,
the International Accounting Standards (IAS), both as IAS and IFRS, are principle-based.
The debate on which is better will be put to rest when the US GAAP converges with IFRS eventually and
becomes principle-based. Being principle-based means that broad principles are laid out by the standard-
fixing body and the interpretation is left to the users of these standards.
The problem (and also the benefit) with principle-based accounting is that most of the times, in a situation
that requires a finding, one will have to exercise a great deal of judgment based on substance as opposed to
a readymade solution being available for a particular issue prescribed in the rule-based accounting.
While the US accounting is considered to be rule-based, one can find echoes of principle-based accounting
also in it. In the widely publicised 1969 case of Continental Vending where the auditors were questioned for
lack of professional standards, the court gave a direction to the jury to look at the facts and the substance of
the case rather than rules of accountancy and mere adherence to GAAP.
The court held that in the audit report the statement ?fairly presented ? in accordance with generally
accepted accounting principles? is two statements rather than one, i.e., ?fairly presented? is principle-based
and the other ?in accordance with generally accepted accounting principles? is rule-based.
Problems for auditors
The preparation of financial statements in accordance with the GAAP in a rule-based environment, however,
presents problems to the auditors. If an auditor were to confront the management over a certain treatment of
a transaction, the management is likely to ask the auditor ?show me where it says I can't do that?.
In other words, in a rule-based environment, the onus is on the auditor to demonstrate clearly that the
particular treatment is not permitted and hence closes the avenues for the auditor to develop further
arguments that would be available in a principle-based accounting environment ( Principles-Based
Accounting, by Ronald M. Mano, Matthew Mouritsen and Ryan Pace, published in The CPA Journal,
February 2006).
Since accounting standards followed in India have their origin in the IAS, the Indian accounting standards
are principle-based. However, there are exceptions to the rule. One prime example is the Income
Recognition and Asset Classification (IRAC) norms prescribed by the Reserve Bank of India for provisioning
for non-performing assets applicable to banks.
Thus, where if any asset is non-performing, based on certain prescribed criteria, a provision is created for
the potential loan loss irrespective of the security available with the bank.
Subjectivity issue
Principle-based accounting has its own issues too. Ian Wright, Director of Corporate Reporting at the
Financial Reporting Council of UK, writing in accountancy magazine (October 2008), talks about the
subjectivity that is present in the IFRS.
The IFRS is full of words and phrases that are open to interpretation. The accompanying table has a
selection of the probabilities in IFRS literature that a user is expected to interpret in the context of
understanding what an accounting standard requires.
Ian Wright also identifies other issues that are potentially problematic.
The IFRS literature contains an increasing range of technical terms which don't translate well into languages
other than English. Also, the standards were written in different eras and sometimes by individual national
standard-setters due to which the usage of the English language differs resulting in them being structured in
disparate ways.
One can therefore see the potential hazards in interpreting a principle-based accounting standard that
contains highly subjective phraseology.
In this context, one can expect problems of interpretation in India also. For instance, the word ?shall? (a key
word in accounting standards) is used in a manner that is completely different from its usage in countries
where English is the mother tongue. Any user of IFRS would therefore need to be alive to these issues when
interpreting IFRS.