Definitions and meanings:
Principle based accounting:
Principle based accounting suggests a ‘comply or explain’ policy. It means every company following this system must comply by the set principles and if a company fails to comply it must present a reasonable explanation for deviation from the principles. The IFRS’s (International Financial Reporting Standards) are a principles based accounting system. IFRS’s are used in almost 120 countries around the globe.
Rules based accounting:
A rules based accounting system as the name implies simply suggests a ‘tick box’ approach. It means that every company following a rules based system must comply with all the rules and regulations and must not deviate from the rules. GAAP (Generally Accepted Accounting Principles) is a rules based accounting system. GAAP is an approach or method used in United States.
Difference between principle based accounting and rules based accounting:
The main points of difference between principle based accounting and rules based accounting are given below:
When applying a principle based accounting system, the accountant not only follows a loosely regulated set of principles but is also expected to apply his or her own judgment while making decisions about the implementation of accounting essentials. A rule based accounting system establishes set line of rules that need to be obeyed in every situation which restrict the accountants to apply their own professional skepticism.
2. Legal aspects:
In IFRS’s the accountants and auditors have to apply their own knowledge of accounts to follow the best choice between whether to apply the IFRS’s in a certain situation or not whereas, while applying GAAP there is no room for any changes except to follow rules strictly. This can lead to accountants not assuming their professional duty of working in the best interest of general public and the company and can easily blame the rules if a law suit is proceeded against them.
A principle based accounting system offers more flexibility to the companies because it allows for the principles to be adjusted according to individual needs of each company if followed by reasonable justifications. However, rules based accounting system does not provide this privilege and companies following this set of accounting system must have to adhere to all the set rules in all circumstances.
GAAP a rules based accounting system is used in United States. IFRS’s a principle based accounting system has been adopted partially or completely by almost 120 countries in the world. Governments and companies in the world prefer IFRS’s more as these standards provide a breathing space to the companies and try to accommodate needs of businesses more progressively.
Standardization is important because it makes it easier to compare financial results amongst different companies. Although, IFRS’s promote standardization as every company must follow the same principles for recognition of liabilities, assets and capital and for reporting financial results but it provides companies the flexibility to vary from the set principles if it will show a clearer picture of company’s financial operations which can result in lack of consistency in published results by different entities. However, US-GAAP is a rigid system of rules and no individual company can choose to deviate from the set rules. Therefore, the financial results of all the companies are prepared by same regulations which offers more standardization and comparability.
Principle based accounting versus rules based accounting
A tabular comparison of principle based accounting and rules based accounting is given below:
|Set principles and accountant’s own judgment is applied.||Only rules are followed.|
|Accountants are assumed to apply their best judgment, therefore they can be held accountable under legal situations.||Accountants can avoid legal charges or responsibility by ascertaining the fact of following rules and regulations.|
|Provides flexibility to companies in certain situations if can be duly explained.||Rules have to be followed as they are without any other choice.|
|Applied in almost 120 countries except USA.||Applied in USA.|
|Can restrict standardization and comparability because it provides a set of thresholds instead of strict border lines.||Promotes standardization because same rules are followed by every company under every condition.|
Conclusion – principle based accounting vs rules based accounting:
Both the accounting systems provide detailed guidelines about the preparation and publication of financial statements of companies. This is important especially for large listed companies because these companies have to publish their financial statements under statutory requirement. Although GAAP is a more stringent accounting system, most of the jurisdictions adopt IFRS’s because it is often in the interest of companies to mold accounting principles according to their needs rather than altering company’s operations. FASB (Financial Accounting Standards Board) a non-profit organization which is the primary body for setting and improving GAAP suggest increased flexibility in GAAP. The body suggests that when accountants, auditors and other standard setters apply their professional judgment along with the set guidelines, it can enhance the quality of financial reporting as a whole.