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New Responsibility: The Slow Rise of Principles-Based Accounting

The debate between principles-based and objectives-based accounting is not a recent one: The 2000s were filled with studies on principles-based accounting and its potential impact on the business environment.

As corporations searched for ways to reform their practices, create internal transparency guidelines, and present a more authentic image to the public, theorists proposed a broader change—the inclusion of principle-based guidelines in American accounting.

Objectives-based accounting relates almost entirely to meeting strict, quantitative goals as explained by American Generally Accepted Accounting Principles (GAAP). The rules in GAAP focus on specific methods of accounting, data that must be provided, and what information must be provided (and to whom) in a given situation. Principles-based accounting, on the other hand, is focused more on the meaning behind accounting actions rather than meeting specific data requirements.

Objectives-based accounting is useful for training, enforcement, and legal proceedings: It helps accountants across all industries understand their work and know how to account for specific transitions in the right way. However, it presents a struggle when it comes to preventing fraud and encouraging customer trust in big brands. Corporations, as have been seen in the past, can meet legal requirements while still subtly committing fraud and working through loopholes behind the scenes. Principle-based systems prevent companies from committing “legal” crimes and finding loopholes by addressing motivations and effects in a gray area, rather than using nothing but black-and-white numbers to define honest practices.

Advocacy for principle-based practices focuses on the economic benefits, resulting in greater trust and more flexible accounting. However, the costs of incorporating changes at the national level are high; as Accounting Web points out, such a gray system can lead to confusion, uncertainty, and a number of legal problems when courts have to rule on financial behavior. A hybrid version, where the current objectives system incorporates elements of a principles system, may be the best bet for increasing trust in corporate financial practices, but also takes the most work.

On a business-by-business level, companies can still choose whether to embrace principles or objectives accounting internally as long as they meet all external qualifications. Principle-based accounting is particularly attractive for companies that want to improve their image and give their accountants greater freedom in representing financial information, but indications show that flexibility comes with a cost. An early 2013 study by the University of Iowa indicates that principles-based firms are more likely to be sued than objectives-based companies, which are perceived as more airtight.

The difference between the two systems holds particular meaning for global business as the SEC prepares to adopt mores parts the International Financial Reporting Standards (IFRS). The evolution of American standards makes it easier for companies to forge international partnerships, but IFRS is considered much more principles-based than traditional U.S. rules, creating the need for a better understanding of the gray areas heading into the future.

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