Rules-Based vs. Principle-Based Accounting
Both rules-based and principle-based accounting systems are meant to provide the best possible financial statements to investors. Under principle-based accounting, management has discretion about how to record a transaction. For example, it might decide to write off a $100 wastebasket as an expense, while another company records the wastebasket as an asset. In a rules-based system, management must follow a specific rule, such as that any purchase above $100 is capitalized.
Most accounting systems include a mixture of principles and rules. Principles are necessary for recording new types of assets, such as foreign mortgage securities or insurance contracts, where there is no domestic rule that clearly defines the asset. Rules are useful when investors would be harmed if a company could classify a transaction any way it wanted to, such as a publisher recording magazines on the shelf at a bookstore as sold when the publisher has to take the magazines back if the bookstore can't sell them.
The mostly rules-based system, Generally Accepted Accounting Practices, governs most financial reporting in the United States. The more principle-based International Financial Reporting Standards is a system that allows more flexibility, because nations have different accounting laws, but the goal of this standards system is to allow a company to provide a set of financial statements that are useful to international investors.
Principle-based systems prevent certain types of manipulation. For example, if the company had to expense a $99 wastebasket but could capitalize a $101 wastebasket, the company has an incentive to purchase a more expensive wastebasket to increase its assets and reduce its expenses, even though stockholders would prefer the purchase of a cheaper wastebasket.
A rules-based system can improve the comparability of companies' financial statements. If two restaurants purchase the same type of oven, one restaurant owner may decide that the oven will last for six years, while the other restaurant owner believes that the oven has a seven-year life span. The restaurant owner who thinks the oven will last longer reports lower depreciation costs. A rules-based system that establishes a depreciation period of six years for an oven removes this subjective factor.
If an auditor can apply a rule, he can use the rule to defend his decision, while a subjective judgment may require the auditor to collect more supporting information. Establishing well-defined rules can reduce the amount of work the auditor has to perform, reducing the cost of the audit.