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.
- University of Georgia; International Financial Reporting Standards and Aggressive Reporting; Ann G. Backof et al; September 2010
- "Graziado Business Review"; All IFRS-Compliant Statements Are Not Equal; Roger Hussey; 2008
- "Accounting Horizons"; A Research-Based Perspective on the SEC's Proposed Rule; Karim Jamal et al; March 2010
Ethics & the Golden Rule
Within a code of ethics, the Golden Rule typically functions as a consistency principle: something to govern more concrete rules in the...
The Difference Between Principles & Rules-Based Accounting Standards
Companies use accounting to detail their financial information in readable reports. In the United States, generally accepted accounting principles (GAAP) are the...
Advantages & Disadvantages of Principles-Based Accounting
Each year companies are required to prepare their financial statements according to the rules set out by the Financial Accounting Standards Board....
Financial Depreciation Vs. Tax Depreciation
Financial depreciation consists of accounting rules that a corporation must follow to depreciate a fixed asset over its "useful" life. A "useful"...
Value-Based Leadership Vs. Skill-Based Leadership
Value-based leadership and skill-based leadership are two philosophical approaches to leading, managing and even working. While not necessarily being opposites, they ...
Basic Accounting Rules
The Matching Principle is a GAAP directive stating that companies must match expenses to revenues in the same period that the revenue...
Comparing GAAP Accounting vs. Tax Accounting
There are two choices when selecting an accounting method for your business: GAAP, which stands for Generally Accepted Accounting Principles, and Tax...
How to Compute Depreciation Based on Mileage
Depreciation is defined as the expense associated from using an asset. If your company has an automobile used for business, this automobile...
FASB Depreciation Method
The Financial Accounting Standards Board (FASB) creates the generally accepted accounting principles, or GAAPs, that govern accounting as practiced in the United...