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Unit 3: Principles of Accounting

than being a primary qualitative characteristic which information must have if it is to be Notes
useful.

Example: A businessman starts a textile mill. Take only two items weaving machine and
bulbs for light in the offi ce. He will purchase these items for his business. From the accounting
point of view, weaving machine is more important than bulbs. Therefore, distributing the cost of
machine over various years is important. But, it is not so important to distribute the cost of bulbs.
If an accountant starts keeping the details of each bulb, then his work would be unduly burdened
with every small detail. It is also not useful for the businessman to know every small details since

it does not affect the financial position in any signifi cant manner.

Caselet Rule versus Principle

tudents of accounting would be well aware of the long discussed differences between
rule-based accounting and principle-based accounting. Both have their protagonists.
SWhile the US GAAP is rule-based, the International Accounting Standards (IAS),
both as IAS and IFRS, are principle-based.
The debate on which is better will be put to rest when the US GAAP converges with
IFRS eventually and becomes principle-based. Being principle-based means that broad
principles are laid out by the standard-fixing body and the interpretation is left to the users

of these standards.

The problem (and also the benefit) with principle-based accounting is that most of the

times, in a situation which requires a finding, one would have to exercise a great deal of
judgment based on substance as opposed to a readymade solution being available for a
particular issue prescribed in the rule-based accounting.
While the US accounting is considered to be rule-based, one can find echoes of principle-

based accounting also in it. In the widely publicised 1969 case of Continental Vending
where the auditors were questioned for lack of professional standards, the court gave a
direction to the jury to look at the facts and the substance of the case rather than rules of
accountancy and mere adherence to GAAP.
The court held that in the audit report the statement “fairly presented … in accordance
with generally accepted accounting principles” is two statements rather than one, i.e.,
“fairly presented” is principle-based and the other “in accordance with generally accepted
accounting principles” is rule-based.
Problems for Auditors

The preparation of financial statements in accordance with the GAAP in a rule-based
environment, however, presents problems to the auditors. If an auditor were to confront
the management over a certain treatment of a transaction, the management is likely to ask
the auditor “show me where it says I can’t do that”.

In other words, in a rule-based environment, the onus is on the auditor to demonstrate
clearly that the particular treatment is not permitted and hence closes the avenues for
the auditor to develop further arguments that would be available in a principle-based
accounting environment (Principles-based Accounting, by Ronald M. Mano, Matthew
Mouritsen and Ryan Pace, published in the CPA Journal, February 2006).
Since accounting standards followed in India have their origin in the IAS, the Indian
accounting standards are principle-based. However, there are exceptions to the rule. One

Contd....

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