Principles Based Accounting Standards – Definition

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Principles-based Accounting Standards Definition

Principles-based Accounting Standards refers to a set of rules and guidelines that organizations must follow when making financial reports. Different states and countries have accounting principles that guide them when reporting their financial data, in the United States, for instance, companies must abide by the generally accepted accounting principles (GAAP) so as to remain listed on the stock exchange.

Principle-based accounting standards are compiled by boards of states. In the United States, GAAP was set by the Financial Accounting Standards Board (FASB).

A Little More on What is Principles-Based Accounting Standards

Companies make financial reports to regulatory bodies or tax agencies annually, semi-annually or monthly. When preparing financial reports, there are some set of principles they must comply with, these are known as accounting standards. Accounting standards are often set by private or non-profit organizations and these rules and guidelines vary across the globe. In the United States, the Financial Accounting Standards Board (FASB) has a responsibility set GAAP and ensure they are complied with by organizations in the U.S.

Despite the variations of principles-based accounting standards across countries, they all have some qualities in common. FASB has 11 concepts which include consistency, accounting period, dual aspect, materiality, money measurement, realization and conservation.

Accounting standards also vary from company form company, while medium and small businesses have simplified accounting standards they must follow, there are strict accounting standards public companies are expected to stick to when making financial disclosures and reporting. Vital elements of accounting standards include specification of monetary units, identification of the entity reporting, reporting time frames, among others.

Accounting Standards

In the United States, the FASB makes certain pronouncements known to be part of the generally accepted accounting principles. These serve as information and guidelines that companies must follow when making financial reports. The FASB pronouncements include Statements of Financial Accounting Concepts, Statements of Financial Accounting Standards, FASB Technical Bulletins, EITF Abstracts, and FASB Interpretations.

Accounting standards vary across countries of the globe, most standards are set based on the financial data prevalent in the country. In the United States, the major standards of the Financial Accounting Standards Board (FASB) include Revenue recognition, derivative accounting, variable interest entities, credit losses, leases (balance sheet), stock options, pensions, and others.

Major FASB Standards

According to the history of principle-based accounting standards which were set and used mostly in the 21st century, there are some drawbacks on these accounting principles. Despite that, they present a set of guidelines that companies must follow when making financial reports, fraud was prevalent at this time, to the extent that they were unnoticed by external auditors. The major examples of accounting irregularities in the 21st century were those of Enron and Worldcom.

Benefits of Accounting Standards:

The major benefits of accounting standards are highlighted below;

  • Accounting standards increased transparency in the financial report of companies.
  • These standards created a formal guideline for accountability by businesses and organizations.
  • Accounting standards reduce fraud and covering of debts and losses mostly practiced by companies.
  • These are sets of regulations created to prevent financial crackdown in businesses.

References for Principles-based Accounting Standards

Academic Research on Principles-based Accounting Standards

  • ¬†Defining principlesbased accounting standards, Shortridge, R. T., & Myring, M. (2004). Defining principles-based accounting standards. The CPA Journal, 74(8), 34.
  • ¬†Financial reporting outcomes under rules-based and principlesbased accounting standards, Collins, D. L., Pasewark, W. R., & Riley, M. E. (2012). Financial reporting outcomes under rules-based and principles-based accounting standards. Accounting Horizons, 26(4), 681-705. This archival study addresses whether the presence or absence of ‚Äúbright lines‚ÄĚ in a lease accounting standard influences the classification of leases as capital or operating. To the best of our knowledge, our study is the first archival research to address the association between lease classification decisions and the use of U.S. GAAP and IFRS lease accounting standards. We examine firms’ lease classification decisions using 2007‚Äď2009 data from a matched sample of members of the Fortune Global 500 that report under U.S. GAAP and IFRS. Consistent with experimental work by Agoglia et al. (2011), we find strong evidence that U.S. GAAP firms using a lease standard containing bright-line guidance (i.e., ASC 840) are more likely to classify leases as operating than IFRS firms adhering to a lease accounting standard that lacks the bright lines of the U.S. standard (i.e., IAS 17). Also consistent with Agoglia et al. (2011), we find little evidence of increased dispersion accompanying financial reporting under IFRS. In fact, we find some evidence suggesting the use of IFRS may actually lead to lower dispersion in reporting outcomes.
  • ¬†Rules-based and principlesbased accounting standards and earnings management, Beest, F. V. (2009). Rules-based and principles-based accounting standards and earnings management. Using a sample of accounting irregularities, this study investigates whether rules-based characteristics are associated with the dollar magnitude of earnings management, with the probability of being penalized by the SEC when earnings management is detected, and with the assessed penalty. To address these questions, I develop an instrument that measures the extent to which a standard contains rules-based characteristics. I find rules-based characteristics are positively associated with the dollar magnitude of earnings management. I also find a negative association between rules-based characteristics and the probability of being penalized by the SEC via enforcement actions. These results suggest the magnitude of earnings management is greater when a rules-based standard is violated and the likelihood of being penalized by the SEC is lower for detected rules-based violations.
  • ¬†Do principles‚Äźbased accounting standards lead to biased financial reporting? An Australian experiment, Psaros, J. (2007). Do principles‚Äźbased accounting standards lead to biased financial reporting? An Australian experiment. Accounting & Finance, 47(3), 527-550. International accounting standards are deliberately designed to be principles‚Äźbased (i.e. ‚Äėsubstance over form‚Äô). With Australia’s recent adoption of international accounting standards, a relevant question is, do principles‚Äźbased accounting standards lead to biased financial reporting? The present paper describes a study that analysed the consolidation judgements of senior accounting officials from Australian listed companies. Participants made consolidation judgements based on AASB 1024 Consolidated Accounts. Although AASB 1024 is not identical to IAS 27 Consolidated and Separate Financial Statements, there are many similarities and both follow a principles‚Äźbased approach. In aggregate, the present study finds that principles‚Äźbased accounting standards do not necessarily lead to biased financial reporting.
  • Principlesbased accounting standards, Gill, F. (2002). Principles-based accounting standards. NCJ Int’l L. & Com. Reg., 28, 967.
  • Further evidence of earnings management and opportunistic behavior with principlesbased accounting standards: The case of conditional asset retirement ‚Ķ, Fornaro, J. M., & Huang, H. W. (2012). Further evidence of earnings management and opportunistic behavior with principles-based accounting standards: The case of conditional asset retirement obligations. Journal of Accounting and Public Policy, 31(2), 204-225. FASB Interpretation No. 47 (FIN 47) clarifies the diverse accounting practices for conditional asset retirement obligations (CAROs) that arose under SFAS No. 143, which is classified as a principles-based standard by the SEC. Prior research suggests that the subjectivity in SFAS No. 143 provides management with the opportunity to manage earnings and avoid the recognition of CAROs. This study examines firms that recorded adjustments for CAROs upon FIN 47 adoption. We demonstrate that effective monitoring is essential to promote adherence with principles-based standards, and that gatekeepers may not be effective when standards are ambiguous. Univariate tests and logistic regressions reveal that FIN 47 adopters have audit committees with a greater number of financial experts and are audited by BIG 4 firms. Particular firm-specific factors are also found to be associated with the adoption decision. The results also indicate that newly-reported obligations related to asbestos in firm-owned property and restoration costs for leased premises were subject to prior management discretion. This study extends existing literature on SFAS No. 143 and FIN 47 and studies examining earnings management with principles-based standards. The case of FIN 47 provides further evidence that significant opportunities for earnings management and discretion exist within a principles-based accounting environment, particularly when standards lack clarity. It also confirms the critical role of monitoring by the audit committee and external auditors to promote adherence with the substance of such standards.
  • The sensibility of principlesbased accounting standards, Mano, R. M., & Mouritsen, M. L. (2004). The sensibility of principles-based accounting standards. Strategic Finance, 85(11), 55.
  • The effects of principlesbased accounting standards on accounting quality, Kohlbeck, M., & Warfield, T. (2005). The effects of principles-based accounting standards on accounting quality. We investigate the accounting quality effects from implementing four accounting standards, which contain key elements of a principles-based accounting system. Consistent with the definitions for assets and liabilities in the conceptual framework, the FASB’s approach to standard setting has recently focused on the balance sheet. We therefore examine the influence of four major balance sheet-oriented accounting standards on accounting quality. We provide evidence that forecast error, forecast dispersion, and the explanatory power of a valuation model are positively affected by the balance sheet accounting standards – especially with respect to pensions and other post-retirement benefits. Increasing accounting quality based on analyst forecast measures is documented even in the presence of expected increased earnings volatility. These results are consistent with benefits to analysts and investors from the new information provided by the accounting standards. Thus, we provide evidence based on existing standards that can be used to assess the merits of a principles-based model for future standard setting.

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