Each year companies are required to prepare their financial statements according to the rules set out by the Financial Accounting Standards Board. The reporting scandals of the early 2000s have prompted the SEC to re-evaluate available accounting methods. One current development is the greater use of a principles-based accounting method instead of the rules-based method. This new method gives companies accounting advantages and disadvantages due to its flexibility.
What Is Principles-Based Accounting?
Principles-based accounting relies on general guidelines for accounting. Instead of providing exact rules for each situation, the principles-based accounting method gives reporting goals that an accountant should meet however he deems appropriate. Rules are provided for accounting situations but are meant more as an example. It is up to each company to determine how it will meet their required reporting goals. The generally accepted accounting principles, known as GAAP, is a well-known form of principles-based accounting.
The other form of accounting is the rules-based accounting method. Rules-based accounting lists out an exact set of requirements that must be followed in preparing a financial statement. There is no flexibility accounting decisions and these regulations must be followed. The rules-based accounting method creates more standardised accounting statements than the principles-based method.
The main advantage of the principles-based accounting method is its flexibility. As the financial world becomes more complex, it becomes increasingly difficult to create standardised rules for the whole economy. Principles-based accounting allows companies to prepare their financial statements as they see best to ensure accurate disclosure of their current situation. The strict format of rules-based accounting made disclosure more work and at times less informative. For example, a company would not have the ability to list industry specific data in the manner it thought best. The principles-based method gives this flexibility.
The flexibility of the principles-based method creates its own set of issues. Since each company can prepare its statements in its own manner, accounting statements will vary in style. This makes it more difficult to compare companies, especially across different industries. Another problem is that principles-based accounting puts more responsibility on the company. Without a strict set of accounting rules, a company is more likely to make a reporting mistake that can lead to legal problems. The greater risk of the principles method is the downside of its flexibility.