Like others, we've watched a slowly developing controversy over the question of whether accounting standards should be "principles-based" or "rules-based." When Sarbanes-Oxley was passed, it required the Securities and Exchange Commission to produce a report on the difference, which the commission completed in July 2003.

More recently, Sir David Tweedie of the International Accounting Standards Board brought it to the forefront in an interview, noting that International Financial Reporting Standards are principles-based, while the American cousins at the Financial Accounting Standards Board are still hammering out rules-based standards, with a subtle implication that they're inferior.


In virtually all popular debates, real complexity never gets articulated because doing so would force the masses to actually analyze issues and reach their own judgments. As a result, very complicated questions tend to first get dumbed-down and then served up with a spin promoting the favored view. Some might say, for example, that gun control is an issue of whether "preventing violence on the streets is preferable to allowing hunters to shoot innocent animals," thus making it difficult to disagree with controlling access to weapons. However, if the issue is framed as "individual freedom versus totalitarian government power," then the clear choice is against gun control.

We think that this same manipulation is occurring in financial accounting, and we suspect that the intent is to provide managers with more discretion so they can paint prettier pictures.

In what we've read, "principles-based" comes across as high-minded and noble, as if these standards exist on an exalted plane far above the world. In contrast, "rules-based" standards seem inferior, even boringly mundane, as if those who support that approach are capable of only narrow and short-sighted thinking. Thus, when forced to choose, most will say that they prefer principles-based over rules-based standards to avoid sounding like they just fell off the turnip truck.

So, to those who would frame the issue in this black-and-white way, we say, "Not so fast, there's more to it."


Before anybody can state a preference, they need a clear understanding of the task at hand, even if the question is as simple as, "Do you need a screwdriver or a hammer?" In that vein, it makes sense to ask why accounting standards are created.

One reason is instructing neophyte practitioners who need an idea of what's going on so they can join the profession and operate within acceptable boundaries. Financial statement preparers and their auditors also benefit from having standards that help determine how to report transactions and events. Likewise, the job of regulators is made easier when standards define limits that let them identify violations.


In racing, it's understood that some horses do better on a certain track depending on its length, turning radius, and surface. In the same way, it makes sense for standards and other guidance to take on different forms according to the purpose they serve.

In fact, educators need high-level concepts for explaining to beginners what accounting is supposed to accomplish and how. Broad principles help novices learn the lay of the land without getting bogged down in myriad details. In the same way, theoretical thinkers who cast a vision for better ways to do things prefer broad principles that don't need to address tough implementation problems that divert them from the "big picture" issues. For example, a visionary might say, "All assets should be reported at fair value," without specifying exactly how to gather that information in all circumstances. While those important practical issues need to be resolved, the work is better done at the implementation level.

Some might suggest that statement preparers, like students and educators, also like broad principles because they provide the opportunity to customize their reports to best reveal economic substance. Of course, what one person sees as a helpful picture may be viewed by others as a highly burnished and touched-up image. Bottom line, preparers seem to like standards that provide at least some discretion in reporting, even at the risk of being perceived as manipulative.

On the other hand, audit practitioners find comfort in detailed rules that help them avoid recrimination. Such narrow rules defining right and wrong protect them against liability if they make the right choices.

Regulators who must enforce laws also prefer specific rules so they can determine when violations have occurred. It's much easier to charge someone with fraud, negligence or malfeasance when a standard clearly states what should have been done. (Paul Miller remembers participating in a briefing at the SEC some years ago prior to a meeting of the Emerging Issues Task Force where several proposed interpretations of the literature were going to be under consideration. The chief accountant finally ended the discussion by telling the staff, "I don't care which one you pick, just be sure we can enforce it.")


Yet another factor that shapes standards is the need to resolve political struggles. For example, when the Accounting Principles Board addressed marketable security investments in 1973, it published an exposure draft calling for them to be reported at fair value with gains and losses flowing through current income. The board never issued the opinion because it disbanded shortly thereafter when FASB was created.

In 1975, FASB released a compromised standard. By recognizing changes in value only below original cost, it reduced auditors' exposure to charges of overstating assets and income. By parking these unrealized losses in equity on the balance sheet, it protected managers' earnings from volatility produced by risky investments.

When FASB returned to this topic in 1993, it proposed exactly what the APB had put forward and was hammered by bank managers who didn't want volatile reported earnings. While both gains and losses are now recognizable under SFAS 115, they are still parked on the balance sheet. Once again, this debate is alive in a joint project involving both FASB and the IASB. This convoluted history shows that the standards were being developed and modified to please vocal constituents, rather than provide useful guidance in either principles or rules.

We observe that those who use political influence are satisfied with rules filled with words like "if," "unless," "in the case of," and "except for." Such complex standards assuage the powerful, but are not good for educating, casting a new vision, protecting accountants, or equipping regulators. Lost in the discussion is any consideration of what would be the best way to inform investors and creditors.


It's clear there is no simple answer to the issue of whether standards should be principles-based or rules-based. The contexts in which standards are applied are too distinct to allow one set to serve all needs.

Specifically, today's conceptual frameworks actually consist of principles-based standards that are helpful for education and for helping standard-setters and others cast visions for what could be done. In contrast, the more common technical standards are fine for constraining what can be done. In fact, it's hard for us to envision an effective system that doesn't generate both kinds. For example, recall the principle offered earlier: "Report assets at fair value." While we think it's a good concept, we acknowledge that it's inadequate for guiding preparers, protecting auditors, and assisting regulators in keeping the capital markets humming along.

But what about those political situations?

The best thing to do is get rid of them by insisting that standard-setters produce only what we call "principles-based rules." In its July 2003 report, the SEC called these standards "objective-based" because the rules would follow from and work toward broader reporting objectives. This idea is equivalent to ours and, either way, the outcome would be no more convoluted rules like this one that FASB just published in Accounting Standards Update 2009-04: "Freestanding derivative instruments that are classified in stockholders' equity pursuant to Subtopic 815-40 are not subject to ASR 268. (Footnote 6: A freestanding derivative instrument would not meet the conditions of Subtopic 815-40 to be classified as an equity instrument if it was subject to redemption for cash or other assets on a specified date or upon the occurrence of an event that is not within the control of the issuer.)"

There's plenty more esoteric jargon in this document, but that's plenty for making our point. Although it explains what to do, it provides no indication of why the resulting information would be useful to anyone.


So, our answer to the question, "Should accounting standards be principles-based or rules-based?" is a definite "Yes" because accounting needs both. Principles are needed to constrain standard-setters against losing sight of producing useful financial statements. However, rules are needed to guide and protect practitioners, while giving regulators a basis for prosecuting violators who stray outside the lines.

Where we surely differ from others is in our belief that much more work is first needed to beef up the conceptual principles so they can guide an equally extensive effort to reform rules-based standards.

To be clear, this latter reform, even if well done, can't ensure that financial reports meet users' needs because rules-based standards can do no more than establish minimum reporting requirements, not maximums.

Eventually, the search for best practices in financial reporting will realize the advantage of our Quality Financial Reporting paradigm's message that providing more information than rules-based standards require will lower a company's cost of capital by reducing investors' uncertainty and risk. The best part is that the lower capital costs will exceed a company's costs of increasing both the transparency and frequency of financial reports.

Until that happens, what the financial reporting world needs is more principles-based rules.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors

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