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Principles-Based Standards: Substance Over Form

As U.S. companies gear up to comply with International Financial Reporting Standards (IFRS), both the U.S. Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) recognize the need to move toward principles-based standards. These standards address many of the shortcomings of the traditional rules-based and principles-only approaches.

In theory, rules-based standards minimize confusion and the need to apply professional judgment in financial reporting. But, because these standards provide a multitude of exceptions and numeric thresholds, they typically result in an increased level of complexity and lead to divergent accounting treatments for similar transactions. Critics of these standards contend that they invite abuse because companies focus on mere technical compliance rather than on the objectives underlying the rules.

Principles-only standards, on the other hand, consist of loosely defined guidelines with limited implementation directives. Such ambiguity requires executives and accountants to exercise significant judgment. As a result, these standards can reduce reduce the consistency of the application of accounting standards.

Principles-based standards provide a middle ground, addressing the shortfalls of rules-based and principles-only standards by:

• Clearly stating underlying accounting objectives,  
• Minimizing exceptions,  
• Providing sufficient detail and structure to ensure that companies can apply rules consistently, and 
• Avoiding the use of percentage tests

Principles-based standards give companies more flexibility in reporting their financial results. At the same time, they hold management responsible for capturing each transaction's economic substance " ... as defined specifically and framed by the substantive objectives built into each pertinent standard," according to the SEC.

Accounting principles generally accepted in the United States of America (GAAP) contain primarily rules-based standards. However principles-based standards are favored by IFRS, and U.S. companies will be required to comply with them eventually. (See "Prepare Now for the Implementation of International Accounting Standards.")

No single set of rules is likely to eliminate the need for accounting professionals to make occasional judgment calls. A principles-based system, however, remedies several of the ills of other standards and minimizes opportunities for companies to meet a standard's technical requirements while ignoring its underlying objective.  

Questions?
Contact Ken McCreadie at 312-980-2984.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.