Caption: Though accounting standards are generally categorized as principles- or rules-based, that's an oversimplification. IFRS and U.S. GAAP are often viewed as stark examples of each system, but the analysis is frequently framed, unfortunately, in either/or terms.
We all live with uncertainty. Because reducing uncertainty gives us a measure of comfort, we look for ways to bring order to our complex and chaotic world. To help reduce uncertainty, one thing we do to help is agree to follow certain rules.
For example, we agree on what will happen when we approach an intersection that has a traffic light. If the light is green we keep going; if the light is red, we stop. Generally, this works well, until someone runs the red light, either intentionally or by mistake.
We also have rules for intersections without traffic lights, but since those rules are less clear-cut, we are required to use more judgment. We consider whether other cars are approaching, who arrives first, who is on the right and so on. Most likely, we approach those intersections thoughtfully and, perhaps, more warily.
At first blush, accounting systems --which represent agreement on the way transactions, events and circumstances are reported--seem designed to reduce uncertainty in the financial world. Balance sheets balance. Income statements have a bottom line. In fact, young people tell us that they choose to study accounting because they like the notion that you get a certain answer, unlike the law where there is always another argument or a reversal on appeal.
But you don't have to study it for very long before you discover that even in accounting certainty can be elusive. What is a fair value? How much should be included in bad-debt reserves? Is an event more likely than not to occur?
We quickly learn that accounting involves estimates and judgments, which means that accounting, too, involves uncertainty.
Accounting standards are often categorized as being either principles-based or rules-based, but that is an oversimplification. International Financial Reporting Standards (IFRS) are held as an example of a principles-based system, and U.S. generally accepted accounting principles (U.S. GAAP) are held as an example of a rules-based system. Unfortunately, the analysis is frequently framed in either/or terms.
And the Evidence Shows ... Actually, both systems are based on sound principles; both systems have plenty of rules. The principles versus rules analysis is better represented as a continuum, with a pure rules system on one end and a pure principles system on the other. No accounting system to-clay sits completely at either extreme. On the continuum, both U.S. GAAP and IFRS are somewhere in the middle, with the U.S. standards slightly closer to the rules end and IFRS slightly closer to the principles end.
There is some academic research on principles versus rules that suggests there are benefits to rules-based...
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