Introduction
Accounting and finance are the fastest growing disciplines in the world of business. The two disciplines work together to ensure the companies are run efficiently. However, accounting differs from finance in some respects: accounting mainly deals with providing data that helps in measuring the performance of the company. The data is also useful in assessing the financial position of a firm and tax liability of the firm. Finance on the other hand emphasizes on decision making about the company’s financial position and to offer advice about the profits and losses (Bog slaw 2008, p.34). In other words finance makes use of accounting data to make decisions about the firm’s financial condition and recommends the way forward. Accounting prepares the financial statements while finance analysis them for purposes of decision making. Besides use of financial statements for decision making, there are other uses of financial statements. Various persons and authorities have significant interest in the financial statements of a company.
According to Tweedie (2007, p. 6) there are internal users and external users. Internal users include the managers, shareholders and the employees. The external users include the government/tax authorities, institutional investors, lenders, the general mass and media. This has called for strict regulations in accounting and finance to ensure that the interest of all these persons, bodies and authorities are safeguarded (Skinner 1994, p.45). There are rule and principles that have been set by the international accounting and professional bodies to ensure efficiency in accounting and finance. Internationally we have international accounting standards board (IASB) that is charged with the responsibility of developing and ensuring enforcement of international financial reporting standards (IFRS), initially called International Accounting Standards (IAS). These standards are either based on principles or rules. There has been an ongoing discussion concerning the principles and rules based accounting standards. The purpose of this paper is to compare the two approaches to accounting. These shall be discussed in the context of the role of regulation in accounting and finance, the FASB, Conceptual framework, the accounting profession and any other relevant body.
Principe based vs. rules based accounting standard
Currently most companies are required to follow the Financial Accounting Standards Boars (FASB) way of preparing financial statements. FASB and IASB uses the principles based accounting standards. There has been a discussion on whether the principle based accounting standards would serve better than the commonly used rules-based accounting. Following the collapse of Enron and WorldCom companies, the principles based accounting standards have been subject to great criticism.
Rules-based accounting provides rules that must be followed in preparing the company’s financial statements. Rules are very important because they enable the accountants to arrive at the prescribed right decision (Schipper 2003, p. 54). Accountants prefer rules based accounting because they argue that without the rules they might be brought to court in the events they make incorrect judgments regarding the financial statements. They argue that with strict rules the events of lawsuits are mitigated.
Rules are believed to reduce ambiguity and increase accuracy. This spares the management the risk of making incorrect reporting decisions. According to Financial Accounting Standards Board (2002, p. 4) principle based accounting standard is a conceptual basis for accounting. For example, the Generally Accepted Accounting Principles (GAAPs) is a set of principles that stipulates what financial statement should achieve. This approach entails key objectives set to ensure good financial reporting. The main advantage of this principle of this approach is that the broad guidelines set are applicable and practical in several circumstances (Nelson 2003, p.65). Though rules are unavoidable they may not apply in every situation. These precise guidelines and requirements would compel the managers to manipulate the statements to suit what is necessary and compulsory.
The main difference between the two approaches is that in principle based accounting, the accounting standards assumes basic principles and relies on the financial statement preparer’s interpretation and judgments before they can be implemented (Ball 2009, p.23). Rule based accounting on the other hand applies the rules that limit flexibility and judgment of the financial statements preparers. The judgments and interpretation of the financial statements are dictated by the rules and not the financial statements preparers.
Comparison
Advantages of principle based: they are very adaptive to the changing environment and products. This is because the principles are applicable and practical to several situations. They therefore require less maintenance measures.
Disadvantages of principle based: According to Toppe and Myring (2009, par. 6), a company using principle based approaches are difficult to audit with respect to compliance to the principles, consistency in applying the principles and reliability of interpretation across different entities. This is because the principles are general to all entities and they do not attach a value judgment to the financial statements. The judgment and the interpretation depend on the preparers of the financial statements. Their in perpetration and judgment may be hard to audit for consistency. There are dangers of manipulating financial results because the interpretation and judgments are made by individuals.
Advantages of rules based: as opposed to principles based approach, in rules based, auditing for compliance is easier because the judgment and interpretation by the financial statement preparers is restricted (Mergenthaler 2009, p.34). It is also easier to audit for consistency for comparison of financial statements across entities. The rules also mitigate the dangers of manipulation of financial statements because no judgment or interpretation is done by individuals.
Disadvantages of rules based: there is lack of flexibility with respect to changing environment and products. This calls for continuous maintenance.
The role of regulation
According to Cuccia and colleagues (1995, p. 236) the role of regulation in accounting and financial reporting is to ensure that the financial statements are prepared and analyzed according to the agreed accounting and reporting standards. Regulation entails the responsibility of all accounting bodies executing the duty they ere charged with
FASB: stands for financial accounting standards board. It is based in US and is charged with the responsibility of setting and governing accounting and financial reporting. FASB highly supports the use of principle based as opposed to rules based accounting approach.
Conclusion
As arrived at by the IASB and FASB, the principle based accounting approach is the most reliable in reporting the financial statements of a company. How ever rules are not avoidable and should apply in some circumstances.
Reference
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Financial Accounting Standards Board. 2002. Principles-based approach to standard setting. Web.
Mergenthaler R. 2009. Principles-Based versus Rules-Based Standards and Earnings Management. Working paper, University of Iowa.
Nelson, M. 2003. Behavioral evidence on the effects of principles- and rules-based Standards. Accounting Horizons, Vol. 17, pp. 91-104.
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