External reporting is an important part of a public company's duties to the public. These reports largely effect the perception of the company's economic strength. As such, it is important that they are prepared faithfully. To do so, these external reports are governed by the US's current rules-based GAAP. Globally, public companies are most likely using International Financial Reporting Standards, either as a required or an acceptable standard for reporting. There is currently a push to have the US use the same system. While the decision is slow to be made, it warrants a look at what the US convergence with the principles-based IFRS, away from the current rules-based system used today, might bring.
With many systems and classifications, it is not always easy to pin down the right approach to accounting for a transaction. It is almost necessary for there to be multiple reporting methods. For example, there is no one method of valuating inventory that is superior to the others in all industries. Different needs have to be met, so rules are put into place to allow multiple approaches. Those vested in seeing the company succeed might think that the company should use whichever acceptable method reflects the company standing in the best light as possible each year. Changing methods each period can help the perception of the company's health, but it is not in the best interest of those using the created documents. Doing this would make period to period or even industry comparisons difficult or impossible. It makes sense, then, that rules have been put into place to help prevent such presentations of information.
These rules are generally a firm and concrete method of reporting. This does, however, allow a company to target certain areas for favorable classifications, by following the form of the law, but not necessarily the function. In many ways, rules-based accounting can allow for skirting the line of legality. An example would be in area of accounting for leases. Under the current system, leases are classified as capital leases if they are leased for 75% or more of the economic life of the asset, or the present value of the minimum payments are 90% or more of its fair value. There are many advantages to having a lease classified as operating lease over capital lease. The desire to influence classification has created the practice of entering leases for 74% of the asset's life for 89% of its fair value. Without the rule, companies would enter leases under terms that are not substantially different from purchasing the asset, yet taking full benefit of the advantages of a lease. The rule in place helps minimize the advantage of receiving both benefits.
The advantages of the rules-based system do not end there. However close they are to line, so long as they operate within the rules, they are safe from litigation. The switch to the principles-based IFRS removes such security for the company and its accountants. Classifications will be made not from predetermined criteria, but by active decisions and professional judgment. This opens them up to scrutiny, and may be the focus of a lawsuit. Further, the accountants themselves could potentially be targeted should their decisions be questioned. Companies stand to lose both a powerful tool and a level of legal security in the switch.
The switch to IFRS may help increase the integrity of the documents created by the accountants. Classifications will be made by seeing the substance of the transaction, not by the individual details. The decisions made will be based on professional judgments based on a simpler set of principles, over a long checklist of items. This flexibility allows for the more relevant information to produce a more robust report on the situation. While there is a greater possibility of a difference in judgments, there are fewer opportunities for overt manipulation.
The US convergence to IFRS is going to play a role in the years to come. Though the decision is being postponed here, IFRS continues to be used around the world. The timeline for convergence seems to be stretching farther than the initial forecast of 2014. The current rules-based system has its flaws of unclosed loopholes and inflexible reporting, but there are those who prefer it to the principles-based system, where two different reports could be prepared from the same data, based on the perceptions of those reporting.