Principles-based accounting standards encourage accountants to follow the spirit of an accounting concept rather than to follow specific accounting rules. The debate over principles-based accounting has increased as the Financial Accounting Standards Board and International Accounting Standards Board seek to converge accounting standards for global uniformity. Principles-based accounting offers more flexibility and encourages professional judgment but is more difficult to comply with and enforce.
The International Financial Reporting Standards, or IFRS, employ more principles-based accounting, while the U.S.' Generally Accepted Accounting Principles, or GAAP, have more rule-based standards.
The respective accounting standards for leases highlights the difference between accounting principles and accounting rules. To determine whether a transaction is a capital lease, GAAP requires accountants to perform a complex evaluation regarding the present value of the minimum lease payments, the length of the lease and other lease details. IFRS, in contrast, simply states that a capital lease occurs when the risks and rewards of ownership transfer to the lessee.
Principles-based accounting is more flexible than rule-based accounting. The Institute of Chartered Accountants of New England and Wales -- ICAEW for short -- points out that principles are better suited to help accountants respond to rapid changes in a business environment. It can take the FASB years or even decades to amend accounting rules. In contrast, an accounting principle or idea can be applied to new types of transactions or financial instruments immediately.
ICAEW notes that rules-based accounting is mechanical and only encourages accountants to look at the letter of the law. Accounting principles require accountants to look deeper into the substance of the transaction. This promotes sound professional judgment in the profession and instills more of a sense of responsibility in the accountant.
If principles are used rather than rules, accounting information may start to become less consistent. Raymond Thompson, Ph.D., a certified management accountant, points out that it's possible for two accountants to look at the same data and come to completely different conclusions about what the data mean. Two companies with the same assets, in this case, could present them differently on the balance sheet.
Complying with accounting principles is more complex, expensive and time-consuming. If companies are required to constantly interpret principles, they need accounting staff with vast experience and an expert understanding of accounting frameworks. Work that was previously done by a lower-level accountant has to be handled by a higher-level accountant, and more time may be needed to come to a conclusion.
Companies and accounting firms are constantly accused of misstating financial information, but asking judges and juries with no financial experience to interpret accounting principles during enforcement cases may be a bad idea. Sue Anderson, program director for CPE Link, points out that it's hard enough for courts to come to a conclusion based on explicit accounting rules and it would be even worse with accounting principles.