Evaluating concepts-based vs. rules-based approaches to standard setting

INTRODUCTION In its new project on Codification and Simplification, the FASB indicates its intent to evaluate the feasibility of issuing concepts-based standards rather than issuing detailed, rule-based standards with exceptions and alternatives.' Related to this project, members of the FASB board and staff asked the Financial Accounting Standards Committee of the American Accounting Association (hereafter, the Committee) to provide comments on concepts-based standards and to recast two standards as concepts-based. (2) This article summarizes comments of the Committee on issues related to concepts-based vs. rules-based standards. Comments in this article reflect the views of the individuals on the Committee and not those of the American Accounting Association. The Committee strongly supports the commitment by the FASB to evaluate the feasibility of concepts-based standards. (3) We believe that the economic substance, not the form, of any given transaction should guide financial reporting and standard setting, and that concepts-based standards represent the best approach for achieving this objective. Rules-based standards provide companies the opportunity to structure transactions to meet the requirements for particular accounting treatments, even if such treatments don't reflect the true economic substance of the transaction. We recognize, however, that the current plethora of detailed rules has been demand-driven, suggesting that companies may request more guidance than that provided by concepts-based standards. Additionally, a change from rules-based to concepts-based standards magnifies the importance of informed professional judgment and expertise for implementation of standards. Overall, however, we believe that concepts-based standards, if applied properly, b etter support the FASB's stated mission of "improving the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability...." RULES-BASED VS. CONCEPTS-BASED STANDARDS An Illustration of Rules-Based and Concepts-Based Standards In order to make our discussion of concepts-based vs. rules-based standards more concrete, we characterize the accounting standard-setting process and its products as a continuum ranging from unequivocally rigid standards on one end to general definitions of economics-based concepts on the other end. An example of the extreme left (rigid) end of the continuum is: Annual depreciation expense for all fixed assets is to be 10 percent of the original cost of the asset until the asset is fully depreciated. Such a rule leaves no room for judgment or disagreement about the amount of depreciation expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, such a standard lacks relevance due its inability to reflect the underlying economics of the reporting entity, which differ across firms and through time. At the opposite (right) end of the continuum is a provision or rule such as the following: Depreciation expense for the reporting period should reflect the decline in the economic value of the asset over the period. (4) Such a standard requires the application of judgment and expertise by both managers and auditors. The goal is to record economic depreciation of the asset, something about which the manager arguably has more information than anyone else. Many might agree that such a rule reflects the underlying purpose of financial reporting, but argue that it is too costly to implement and would likely lead to results that are neither comparable across firms nor consistent through time. Benefits and Costs of Rules-Based vs. Concepts-Based Standards Rules-Based Standards Evidence abounds that detailed standards cannot meet the challenges of a complex and rapidly changing financial world, and that they frequently provide a benchmark for determining compliance in form but not in substance (Finnerty 1988). …