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Listen to The Students In The Great Debate

Beginning accounting students usually are taught that Generally Accepted Accounting Principles (GAAP) are the essential points of reference as the students progress through their course content. This is a practical and sensible approach because it conveys the essential rules that govern how transactions are currently recorded and presented on financial statements. As well, rules frequently provide the added benefit of stress relief from ambiguity and uncertainty. However, right now among the best and the brightest, the academics and the practitioners, a great debate rages about the entire system of rules, and the discussion is becoming louder and louder.

A Class As a Proxy

Although most students in a beginning accounting class don’t plan on making accounting a career, they still need to understand the accounting process and the essential meaning of the information that appears on financial statements — much like that great part of the non-professional general public who as owners, employees, investors, lenders, and other stakeholders (persons that rely on financial information) require the same basic accounting knowledge. And similar to beginning students, most public stakeholders are sufficiently intelligent, willing, and able to do what is necessary to acquire the essential skills; in fact, because real money is involved and real decisions have to be made, those in the financial public have even more reason to be highly motivated. To me, the questions and issues that arise in a beginning financial accounting class are the same for many if not most public stakeholders and are germane to how the outcome of the great debate will affect the needs of the general public. As a teacher, I also believe it is imperative to make an honest effort to be sure that the students who finish a beginning course (many of whom may never sit in another accounting class) do not blithely move on thinking that all is settled in the world of accounting and that the numbers always tell the story. Besides, sometimes it is fun to be the one who breaks the news.

The Great Debate: Principles vs. Rules

A beginning or basic accounting class, after a short time, is an open invitation to bring up the great debate now in progress. One of the earliest opportunities occurs when students become uncomfortable with inconsistencies and complexities that are part of GAAP. It doesn’t take long before the questions start coming: “Why does this get so complicated?” or “Why does GAAP allow three different methods so we get three different answers?” or “How can you have revenue recognition and matching mean different things for different companies?” The debaters should listen to these kinds of questions, and if it means more, consider them as coming from the general public.

“Principles”, students are taught, are fundamental truths or general rules that describe how something should be done, but do not specify methods of implementation. “Rules” are specific methods or procedures created for the purpose of implementing principles. The debate today: should accounting rely more heavily on principles or more heavily on rules?

The Principles Approach

In the great debate, proponents of principles-based accounting believe that instead of using rigid rules, accountants should apply their best judgment and experience when recording transactions, without having to resort to very many detailed rules. The key idea is that this will encourage the presentation of the real “substance” of a financial event, rather than using inflexible rules or formulas to characterize it. This is often described as “substance over form”. The thinking goes like this: an experienced and ethical accountant will apply a principle in the real spirit and substance in which it was intended, thereby recording transactions and creating financial reports that reliably portray the true financial events of a business. A second important advantage of this approach is that the number, confusing complexity, and in some cases contradictory nature, of rules can be reduced.

The Rules Approach

Supporters of the current rules-based approach believe that rules provide clear and consistent guidance in a complex world — a world in which CFOs and CEOs regularly apply pressure and ‘negotiate’ with auditors to get them to portray transactions in ways that are favorable to the businesses being audited. Rules provide auditors some degree of protection from both these corporate officers as well as lawsuits from angry stakeholders that claim auditors were negligent or complicit in preparing misleading financial information. If accountants follow the rules — they should be safe.

It’s A Revolving Door

If you continue listening to the debate, you will begin to feel like you are moving in a revolving door. You will end up right back where you started. If you like a rules-based system, you will have to admit that all the rules and all the king’s men did not prevent the events at Enron, WorldCom, Global Crossing, Health South, Adelphia, etc., etc. In other words, rules can be gamed. What’s more there are court decisions establishing the precedent that in effect say that even if auditors can show they technically followed the details of the rules, they can still be held liable for fraud or negligence if they do not fairly present (“substance over form”) the financial statements (Continental Vending and cited in other cases). If you prefer principles-based accounting, then you have to admit that you are opening the door to all kinds of original interpretations of financial transactions between accountants and the clients who pay them. You would also have to admit that an experienced and ethical accountant can just as easily apply the spirit of underlying principles in a rules-based system as not. Finally, you would also have to agree that an accumulated variety of good-faith interpretations will give results at least as complex as the existing rules.

What to Tell the Students?

What we might have here is a cultural/ethical problem, not a technical problem. Rules or no rules, a system can be gamed if you really want to do it. And many people want to. That’s unfortunate, because it’s a more difficult problem to fix. Yes, keep things as simple as we can. Stress ethical reporting. If all else fails, remove the conflict of interest and make auditing a public rather than private function, still paid for by companies being audited. And above all — rules or principles — listen to the students’ questions!

By Greg Mostyn, Mission College

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Worthy & James Publishing is a provider of basic accounting books covering fundamental accounting principles, business accounting, and business math. Topics in financial accounting and business accounting covered include generally accepted accounting principles (GAAP), the accounting cycle needed to prepare financial statements such as the balance sheet, income statement, statement of cash flows, statement of stockholders’ equity, and financial statement analysis using ratios and other procedures. Internal control and cash budgets are included.

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