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Ever since the occurrence of accounting scandals such as Enron in the beginning of
the millennium, the principles-versus-rules debate has been on top of the agenda of
securities regulators, especially of the U.S. Securities and Exchange Commission
(SEC), and of national and international standard setters and accountancy bodies,
such as the U.S. Financial Accounting Standards Board (FASB), the International
Jens Wüstemann holds the Chair of Accounting and Auditing at the University of Mannheim. Sonja
Wüstemann (swuestemann@wiwi.uni-frankfurt.de) is Assistant Professor at the Department of Auditing
and Accounting at the Goethe-University Frankfurt am Main.
The comments of David Alexander, Graeme Dean, Niclas Hellmann, Joachim Hennrichs, Jim Osayande
Obazee (discussant), Walter Schuster, Kenth Skogsvik, and Shyam Sunder are gratefully acknowledged,
as are those of workshop participants at the 3rd Workshop on Accounting in Europe at the ESSEC
Business School in 2007 (Paris), the 4th Workshop on Accounting and Regulation at the University of
Siena in 2007 (Siena), the Department of Accounting of the Stockholm School of Economics in 2008
(Stockholm), the 31st Annual Congress of the European Accounting Association in 2008 (Rotterdam)
and the Annual Meeting of the American Accounting Association in 2008 (Anaheim), as well as of two
anonymous referees.
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financial reporting if two enterprises account differently for the same economic
phenomena’ (CON 2.16). It explains the need for consistency in relation to compa-
rability: ‘Comparability between enterprises and consistency in the application of
methods over time increases the informational value of comparisons of relative
economic opportunities or performance’ (CON 2.111). In their draft for a revised
conceptual framework the FASB and the IASB similarly point out that ‘[a]lthough
a single economic phenomenon can be faithfully represented in multiple ways,
permitting alternative accounting methods for the same economic phenomenon
diminishes comparability and, therefore, may be undesirable’ (IASB, 2008, QC19).
Also in the EU, the adoption of a single set of financial reporting standards (IFRS)
is premised on the enhancement of the comparability of financial statements of
publicly listed companies (rationale 1 IAS Regulation). Current efforts aimed at
ensuring a consistent application of IFRS, such as the coordinating national enforce-
ment actions by the Committee of European Securities Regulators (CESR) and
establishing a round table addressing the consistent application of IFRS,1 underpin
the importance of consistency in the EU.
By contrast, in Germany the necessity for internal consistency in general, and
consequently in accounting law, is derived from the legal regulatory framework,
namely the constitutional postulate of justice (Gerechtigkeitsgebot) and the equality
principle (Gleichheitsgrundsatz) according to which the same matters need to be
treated identically and different matters ought to be treated differently (Article 3
German Constitution) (Canaris, 1983a, p. 16). In Japan, there is a third approach,
internal consistency of accounting standards required in order to achieve stable
order (ASBJ, 2004). The ASBJ (2004) further justifies the need for consistency by
arguing that, if existing standards are regarded to result in relevant information and
if a standard dealing with a so far unregulated transaction or event is developed
consistently with existing standards, the new standard typically also leads to relevant
information in an unchanged economic environment.
One can observe that the different notions of consistency are related in such a way
that consistency in the application of accounting standards across companies can
only be achieved if the standards are internally consistent. In a regime that provides
clear rules for each and every accounting issue and in which the application of the
rules does not require the use of any judgment, internal consistency between the
rules would not be required because consistency in the application across companies
would be achieved anyway (AAA FASC, 2003, p. 74). However, such a system does
not exist. The continuous issuance of new accounting standards and interpretations
in rules-based regimes, such as U.S. GAAP reveals that there are always issues not
covered by any existing rule as well as rules the application of which requires
management to use judgment (Penno, 2008, p. 339). In more principles-based
regimes, like IFRS, the application of high-level principles to specific accounting
issues demands the exertion of judgment in many cases.
1
See for details http://ec.europa.eu/internal_market/accounting/docs/ias/roundtable/060220_
roundtable_en.pdf (accessed 22 November 2008).
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loss of consistency in the application. For this discussion, the previous assumption of
consistent application of accounting standards by all companies is relaxed, enabling
critical discussion of the advantages and disadvantages of principles-based and
rules-based accounting standards. For reasons of comparability, enforceability and
objectivity of financial reporting information, it is concluded to be important to have
specific (internally consistent) accounting requirements that limit management
judgment in the application of accounting standards to ideally only one possible
accounting method.We acknowledge, however, that this may, in some situations, lead
to an impaired relevance of financial reporting information.
The quest for internal consistency is shown here to have developed in different
accounting regimes. We conclude that a consistent application of accounting stan-
dards does not only presuppose the existence of internal consistency of high-level
concepts and principles, but also that the rule maker (and managers in the absence
of specific guidance) applies the concepts and principles consistently to all compa-
rable accounting issues. This implies that in an internally consistent accounting
regime there is, in principle, for each transaction and event only one accounting
method that accords to the high-level principles as well as to the specific guidance
relating to comparable accounting issues and thus consistently fits into the entire
‘system’ of norms.
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perceived as a ‘coherent, coordinated, and consistent body of doctrine’, with the aim
to explain and justify the prevailing accounting practice and to suggest improve-
ments to it (Preface, p. viii).
In the 1960s, with the beginning of the a priori research, the desirability of internal
consistency of accounting principles was widely accepted. Instead of deriving prin-
ciples from the prevailing practice, researchers, such as Sprouse and Moonitz (1962),
Edwards and Bell (1961) and Chambers (1966), established consistent theoretical
frameworks independently from the accounting practice and, on this basis, deduced
consequential accounting principles (Haller, 1994, p. 94). Ijiri (1967) also took the
conventional accounting system, especially historical cost valuation, as given. But, in
contrast to Sanders et al., he sought to structure the prevailing accounting practice
logically by means of axioms. According to Hendriksen and van Breda (1992), the
normative accounting theorists ‘attempt[ed] to prescribe what data ought to be
communicated and how they ought to be presented; that is, they attempt[ed] to
explain what should be rather than what is’ (p. 17).
Smith as early as 1912 argued that ‘accounting is, or ought to be, a science . . .
amenable to definite axioms and capable, in proper practice, of producing definite
and exact results’ (p. 112, quoted from Previts and Merino, 1979, p. 162). Ijiri (1967)
seems to have had the same understanding of consistency in accounting. In analogy
to Euclidean geometry, he established a set of axioms, which was supposed to permit
application of the valuation rules ‘in a purely mathematical way without making any
empirical judgment’ (p. 88). This may be regarded as a late reflex of Samuelson’s
re-calibration of economics in his seminal work of 1947 (Samuelson, 1983, pp. xvii
et seq.).
By contrast, the U.S. Supreme Court has, with good reasons, stated that ‘financial
accounting is not a science’ (Shalala v. Guernsey Memorial Hospital, 514 U.S. 87,
1995). Nolan (1972) holds that accounting is different from natural sciences because
‘[t]here is no “right” way of proceeding’ (p. 18). Hendriksen and van Breda (1992)
agree by highlighting that ‘[a]ccounting systems are not purely abstract structures,
nor is the debate over accounting rules purely theoretical in the sense of being
without practical significance’ (p. 112) and that an axiomatic or mathematical
approach ‘is too far removed from reality to be able to derive realistic and workable
principles or to provide a basis for practical rules’ (p. 16). In conformity with this, one
may argue that Hausman’s (1992) statement that economics is an ‘inexact science’
also applies to accounting (pp. 205 et seq.). This debate somewhat imports elements
of the former controversy on the possibility of the value-free social sciences (Wert-
urteilsstreit) into accounting theory and practices (Weber, 1949, pp. 20–1; Blaug, 1992,
pp. 112–4; see on value judgments in accounting Moxter, 2003, p. 9).
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the stated objectives and concepts shall provide ‘the Board with a common founda-
tion and basic reasoning on which to consider merits of alternatives’ (Preface to
‘Statements of Financial Accounting Concepts’). This means that depending on how
much weight the Board members attach to the different concepts and principles in
the Framework (CON 2.10) they can come to different conclusion as regards the
choice of appropriate accounting methods. In this context, Hendriksen and van
Breda (1992) note that ‘the results depend significantly on those who use the con-
cepts to establish accounting standards’ (p. 62). It should, however, be noted that the
Conceptual Framework does not allow an arbitrary use of judgment, but rather
limits the Board members’ and management’s judgment to a small number of
different interpretations.
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specific cases, there is for each case in principle only one accounting method that
meets the statutory value judgments and thus consistently fits into the entire
accounting system.
Discussion
U.S. GAAP, German GAAP (GoB) and also IFRS all require the use of judgment
in the application of accounting standards/norms. German GoB require courts and
therefore, ultimately, managers to use judgment in revealing the one accounting
norm that conforms to the legislator’s value judgment and therefore consistently fits
into the system. This presupposes a consistent balancing between and application of
the high-level principles to all comparable accounting issues, for instance, to all
revenue-generating transactions and events. By contrast, Board members and man-
agers under U.S. GAAP and IFRS are supposed to balance between and apply the
general concepts to specific cases according to their personal professional judgment
(see, e.g., FW.45), which may differ from case to case. This implies that for some
issues there may be several different accounting methods that are all in compliance
with the Framework and between which the Board members or management may
hence choose.
Consistent application implies that comparable issues are accounted for in the
same way across companies (Schipper, 2003, p. 62). We argue that this can only be
achieved if standard setters (and managers in the absence of clear guidance) trade-
off between and apply the general concepts, such as relevance and reliability, as well
as the general recognition and measurement principles consistently to all compa-
rable cases. In an internally consistent accounting regime there can be hence for each
accounting issue only one accounting method that accords to the high-level concepts
principles as well as to the specific guidance relating to comparable accounting
issues.
Impossibility of Consistency
Alexander and Jermakowicz (2006) point out that accounting ‘is most certainly not
a pure science’ and conclude that ‘[i]nternal consistency, as an absolute, is simply not
possible’ (p. 150). In another article Alexander (2006) claims that companies in
different countries will apply IFRS inconsistently in identical cases and that the
enforcement of accounting regulation must accept this (p. 75). We agree that
accounting is not a ‘pure science’ (see above) and that absolute consistency of all
accounting principles is not achievable. Indisputably, one can also agree with Alex-
ander’s assumption that IFRS will never be interpreted and applied fully consis-
tently by all companies. However, as in the case of other ideals, such as justice,
equality and freedom, the impossibility of achieving absolute internal consistency
does not, from a normative perspective, imply that consistency between accounting
norms and their consistent application is not to be desired. Nor does it imply that on
a comparative basis there cannot be more consistent and less consistent accounting
norms.
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We now turn to exploring how far internal consistency is achieved in the IFRS
regime. The IASB Framework is shown to contain contradictory objectives and
qualitative characteristics as well as conflicting general concepts and principles. As a
result, Standards and Interpretations dealing with similar and related issues are
partly inconsistent. From this finding one can infer that a consistent application of
IFRS is currently not ensured. Finally, the IASB’s efforts towards the elimination of
the described inconsistencies are presented.
2
This follows from the definition of financial position in the IFRS Glossary as ‘[t]he relationship of the
assets, liabilities and equity of an entity, as reported in the balance sheet’.
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1920s (see, e.g., Schmalenbach, 1926, pp. 80 et seq.; Moxter, 1984). Sterling (1970, pp.
253 et seq.) and lately Ronen (2008, p. 184–5) are examples in the Anglo-American
literature (see also Benston et al., 2006, pp. 171–6; Bonham et al., 2009, pp. 91–4).
The existing IASB Framework contains both opposing and inconsistent objectives
(FW.15; IAS 1.7). As a consequence, standards contain recognition and measure-
ment principles that reflect different accounting theories and are thus sometimes
inconsistent. The following example illustrates the resulting inconsistencies: The
IASB has given priority to the revenue/expense view in the recognition of govern-
ment grants, since the corresponding income shall be allocated over the periods
necessary to match them with the related costs (IAS 20.12) (see for the incompat-
ibility of IAS 20 with the assets/liabilities view, Nobes, 2005, p. 30). By contrast, in the
case of biological assets the IASB has given priority to the assets/liabilities view
because income shall be recognized independently from the incurrence of the costs
when an increase in wealth (indicated by an increases in the asset’s fair value) has
taken place (IAS 41.12, 41.26).
Furthermore, the existing IASB Framework does not ‘convey . . . the meaning of
reliability clear enough to avoid misunderstandings’ (IASB, 2008, BC2.11). The
IASB (2005a) notes that
[f]or many [Board members], the meaning seems to be verifiability, for some its precision,
for some, it may be faithful representation, for a few perhaps all of those plus neutrality.
Among constituents, the differences in meaning are if anything much greater. (para. 41; see
also Johnson, 2005, pp. 1–2)
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The link is now made between the consistency issue and the rules-versus-principles
debate in the accounting literature. The definitions and distinctive characteristics of
rules and principles are identified based on the legal and accounting literatures. It is
concluded that the removal of many deficiencies currently perceived in relation to
the rules under U.S. GAAP and IFRS does not require a complete elimination of
rules, but could also be achieved by a removal of present inconsistencies. Moreover,
it is demonstrated that a consistent application of accounting standards does not
only presuppose internal consistency of the accounting standards, but also the pro-
vision of rules in the form of specific recognition and measurement requirements.
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cise judgment in applying the principles to specific transactions and events (Tweedie,
2002, 2005, pp. 33–4, 2007, p. 7; DiPiazza, Jr., 2008, p. 7; Tsakumis et al., 2009, pp. 6–7;
see also SEC, 2003, para. I.C.; Psaros, 2007, p. 528).
Tweedie (2002, 2007, p. 7) points out that in an accounting regime that is based on
principles only, many individual transactions and events are not explicitly dealt with
in any standard. In such cases, managers are supposed to select and apply appropri-
ate accounting policies by exercising professional judgment. Dickey and Scanlon
(2006) further note that in a principles-based regime enforcing agencies are only
allowed to second-guess managers’ professional judgment if the selected accounting
policies are not in conformity with the high-level principles or if the judgment was
not made ‘in good faith’ (pp. 16–17; see also Ng, 2004, p. 20; Tweedie, 2007, p. 8;
Bonham et al., 2009, p. 73). They conclude that ‘[t]he “principles-based” approach
theoretically permits public companies to have differing accounting judgments
within the framework of these broad principles’ (Dickey and Scanlon, 2006, p. 13; see
also Coglianese et al., 2004, p. 38; Kivi et al., 2004, p. 12; Tweedie, 2007, p. 8). Some
reference to the ‘true and fair view override’ in British jurisdictions is an example of
such a principle-based regime (see Clarke and Dean, 2007, Chapters 4 and 5).
It seems as if the definition of principles and rules in the accounting literature is
very much in line with that in the legal literature. However, there are also differ-
ences. In addition to the characteristics named above, the SEC and some others
characterize accounting rules as containing quantitative thresholds (bright-line
tests), scope exceptions and inconsistencies, while they consider accounting prin-
ciples as eschewing exceptions and as being devoid of bright lines (2003, I.C.; see also
Bonham et al., 2009, p. 71). Some further note that principles are derived from a
complete and internally consistent conceptual framework (Choi and McCarthy,
2003, p. 6; ICAS, 2006a, p. 1; DiPiazza Jr et al., 2008, pp. 4–5; IASB, 2008, P4; Bonham
et al., 2009, p. 71).
When comparing those additional characteristics with the legal definition of prin-
ciples and rules we remark that those characteristics represent distinct attributes of
principles and rules in the accounting literature, but that they do not form part of the
respective legal definitions. In fact, the characterization of rules in the accounting
literature represents a description of the perceived deficiencies of current U.S.
GAAP and the characterization of principles represents a description of what the
accounting literature regards as desirable. This may explain why rules have become
quite unpopular and why standard setters and accountancy bodies, such as the IASB
and the ICAS, and the international accounting literature so intensely call for
principles.
If one refers to the definition of rules in the legal literature, rules must not
necessarily contain bright-line tests, exceptions and inconsistencies, and they can
also be derived from a complete and internally consistent set of high-level principles.
An example for this is the German accounting system, which comprises principles as
well as more specific guidance, which courts consistently derive from the high-level
principles; therein, even the more concrete guidance is ‘principles-based’ (Beisse,
1990). On the other hand, principles as defined in the accounting literature do not
necessarily have to be internally consistent (Walker, 2007, p. 53).
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We hold that many of the problems related to rules under U.S. GAAP and IFRS,
such as scope exceptions and excessive implementation guidance, do not require the
elimination of all specific guidance as requested by some in the accounting literature.
We argue that they may also be resolved by eliminating the inconsistencies within
the respective accounting regimes. For example, if IAS 39 would require measure-
ment of all financial instruments by reference to a consistent measurement basis the
standard would (automatically) contain much less specific guidance.
DISCUSSION
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tions, thereby circumventing the intent and spirit of the standards’ (Cunningham,
2007, p. 11; see also McBarnet and Whelan, 1991, p. 849; FASB, 2002, p. 2; Kivi et al.,
2004, p. 12; Howieson et al., 2009, p. 15). Principles, by contrast, are regarded as being
hardly susceptible to an evasion of their intended purpose (Broshko and Li, 2006, p.
5) and, due to their flexibility and the required use of professional judgment, as
having the capacity to give consideration to the particularities of individual cases
(Bratton, 2003, p. 1037; Cunningham, 2007, p. 11). Referring to the example above, a
principle could be to recognize all present obligations as liabilities even if the
probability of the resource outflow is less likely than 50%, and to measure them at
fair value (see for a similar approach ED IAS 37).
Another reason why many, for example, Alexander and Jermakowicz (2006),
argue that principles provide more relevant information than rules is that managers
best know the economic reality and how to account for it (p. 150; see also AAA
FASC, 2003, pp. 74, 76; ICAS, 2006b, p. 69). Others, for example, Bagnoli and Watts
(2005), furthermore highlight the positive influence of the existence of implicit
accounting choices on the relevance of financial reporting information by providing
evidence that managers’ accounting policy choices allow the market to infer man-
agers’ private information about the firm’s economic situation (‘signalling effect’) (p.
798; see also Hail et al., 2009, p. 15; see, e.g., Wyatt, 2005, for the signalling effect with
regard to the recognition of intangible assets).
However, the downside of the flexibility of principles is, according to Beechy
(2005), that managers may not always choose the most relevant accounting method
since managers are always biased—even if they do not have fraudulent intentions (p.
199; see also Nelson, 2003, p. 100; Hail et al., 2009, p. 15). Guenther (2005) attributes
this, amongst other things, to the pressure to present good results in the short term,
especially when the personal income is bound to the achieved results (pp. 6, 12–13).
Rentfro and Hooks (2004) additionally remark that the recent corporate scandals,
such as the case of Enron, indicate anecdotally that managers do not always
apply accounting standards in good faith (p. 89; for the possibility of abuse of
imprecise accounting standards see Clarke and Dean, 1992, 1993, 2007). Principles-
based accounting standards are hence criticized for providing increased potential for
earnings management (Beechy, 2005, pp. 199–200; Benston et al., 2006, p. 173; see also
Watts and Zimmerman, 1986, p. 206).
In conformity with this, Ewert and Wagenhofer (2005) find that tighter accounting
standards reduce earnings management. However, they also find evidence that
tighter accounting standards increase real earnings management, that is, a change in
the structure of transactions or events in order to avoid the consequences specified
by an accounting standard (Ewert and Wagenhofer, 2005).
Laux and Leuz (2009, pp. 830–1) provide an example that well illustrates the
above stated conflict between the relevance of managers’ flexibility and the risk of
earnings management: Since the measurement of fair value by reference to market
prices is—if contagion effects exist—not appropriate, managers must deviate from
market prices and determine fair value by means of valuation models in order to
provide relevant information. However, it is often not clear under which circum-
stances market prices are misleading. Laux and Leuz conclude that ‘[m]anagers have
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an information advantage over the gatekeeper (e.g., auditors or the SEC) and, as a
result, it is difficult to write FVA standards that provide the flexibility when it is
needed and constrain managers’ behaviour when it is not needed’ (p. 831).
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