Companies use accounting to detail their financial information in readable reports. In the United States, generally accepted accounting principles (GAAP) are the law of the land. GAAP is a set of conceptual principles rather than a rules-based accounting framework. Major differences exist between a principles-based and rules-based system, with diverging opinions on both sides.
A principles-based accounting system — such as GAAP — provides basic guidelines for accountants to follow. The basic ones found in GAAP include regularity, consistency, sincerity, prudence, continuity, periodicity and good faith, among others that may apply to a company’s operations. In some cases, the principles provide suggestions on how to apply GAAP to complex financial transactions. This leads to different reporting for certain transactions, making it possible for two companies to handle a similar transaction differently.
Rules-based accounting systems provide specific dictates for reporting financial information. Accountants must follow these rules or face penalties for noncompliance. International countries may have a rules-based system. Rules detail how a company should prepare and report financial transactions. Accountants must learn and follow these rules, taking a company’s financial information and forcing it to meet the rules-based system.
International financial reporting standards (IFRS) — the most common international accounting standards set — are not a rules-based system. Most countries prefer a principles-based system as it is often better to mold accounting principles to a company’s transactions rather than molding a company’s operations to accounting rules. IFRS states that a company’s financial statements must be understandable, readable, comparable and relevant to current financial transactions.
Accountants may prefer a rules-based system when compared to a principles-based accounting system. The main reason for this is the removal of legal liability from accountants preparing financial information. Though a rules-based system may be harder to apply in a company’s operating environment, the rules governing financial accounting reports leave no subjectivity in the preparation and evaluation of the documents.