Page 16 - DMGT403_ACCOUNTING_FOR_MANAGERS

Unit 1: Basic Accounting Review

Notes

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 prime example
is the Income Recognition and Asset Classification (IRAC) norms prescribed by the Reserve
Bank of India for provisioning for non-performing assets applicable to banks.
Thus, if any asset is non-performing, based on certain prescribed criteria, a provision is
created for the potential loan loss irrespective of the security available with the bank.

Subjectivity Issue
Principle-based accounting has its own issues too. Ian Wright, Director of Corporate
Reporting at the Financial Reporting Council of UK, writing in accountancy magazine
(October 2008), talks about the subjectivity that is present in the IFRS.
Contd...

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