Question

Explain ‘Rule-based vs. Principle-based‘ approach in setting accounting standard

   - Show the benefits of each approach

   - Any kind of problem in adopting those approaches.

Answer 1

Solution. When an organization decides to run business in competitive economic market, it needs to set accounting standards for book-keeping in order to maximize profits and minimize costs.

Difference between Rule-based vs. Principle-based approach in accounting standard as follows:

a)Rule-based accounting system states how an organization should record and prepare different financial transactions reports. Whereas, Principle-based accounting system establishes primary guidelines for recording and preparing financial reports.

b)Rule-based accounting system is applied in case of Generally Accepted Accounting Principles(GAAP) whereas, Principle-based accounting system is widely applied in case of International Financial Reporting Standards(IFRS).

c)Rule-based accounting system encompasses is more strict in nature and consistent record of activities are made. Principle-based accounting system encompasses different interpretation and analysis of similar financial activity.

d)There exists a major difference of choices in both the systems. For instance, in GAAP, inventory valuation can adopt either FIFO or LIFO method whereas, IFRS relies on LIFO inventory valuation method is used.

Benefits:

In case of Rule-based approach in setting accounting standard, it provides with already existing established procedure of reporting transactional activities.

In case of Principle-based approach in setting accounting standard, it provides with easily understandable, comparable financial details.

Problem:

In case of Rule-based approach the established rules can be time consuming and misleading of interpretation of such can result or lead to manipulation in reporting financial activities. Too many established rules can sometimes also work as constraint during recording of reports in an accounting period and therefore act as a complex process.

In case of Principle-based approach there can exist an uncertain and not reliable course of action. There can exist an inconsistent method of recording revenue system in an organization during an accounting period.