The Difference Between Principles & Rules Based Accounting Standards

by Leon Teeboom; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated May 08, 2019

To explain the difference between rules-based accounting and principles-based accounting, it is necessary to ask yourself which system you think should be adopted. Generally, the principles-based approach is the internationally favored method. Indeed, most companies must prepare their financial statements as dictated by the Financial Accounting Standards Board (FASB), which generally takes a principles-based approach in its standards. In the U.S., however, rules-based accounting is favored.

Principles-Based Accounting vs. Rules-Based Accounting

In accounting, a principles-based on approach is the most popular accounting method globally because it is usually better to adjust accounting principles to a company’s transactions, rather than adjusting a company’s operations to accounting rules. The international financial reporting standards (IFRS) system – the most common international accounting standard – is a principles-based approach, which states that a company’s financial statements must be understandable, readable, comparable and relevant to current financial transactions.

By contrast, rules_-_based accounting involves a list of detailed rules that companies and their accountants must follow when preparing financial statements. The major example of rule-based accounting is the Generally Accepted Accounting Principles (GAAP), which is a system broadly used in the U.S. Rules-based accounting involves – as the name implies – that users follow a list of strict and specific rules that accountants must apply when creating financial statements and other financial documents.

Principles- vs. Rules-Based Accounting Background

The difference between principles-based and rules-based accounting can be a little tricky. Of note, accounting principles have been in existence since the late 1400s, when they were devised by Luca Pacioli, an Italian mathematician. Those early principles developed by Paioli have evolved – and today principles- and rules-based accounting break down as follows:

  • In the United States, modern-day accounting principles are called generally accepted accounting principles (GAAP); these principles guide the work of accountants and auditors. Ironically, generally accepted accounting principles actually involve rules-based accounting. 
  • The U.S. Securities and Exchange Commission delegates the responsibility for developing GAAP to the accounting profession via the Financial Accounting Standards Board (FASB).
  • The International Accounting Standards Board (IASB) develops global accounting standards. Many multinational companies

    even many based in the U.S. –  follow IASB standards.

In sum, guided by the SEC, the GAAP, sets rules-based accounting standards that are used mosty by U.S. firms. The international financial reporting standards (IFRS) foundation sets principles-based accounting criteria that is generally used by companies outside the U.S., as well as many multinational firms.

Key Differences in Rules-Based Accounting vs. Principles-Based Accounting

Rules-based system: Essentially, a rules-based system in accounting is a list of detailed regulations that accountants follow in order to create fiscal statements. Many accountants and comptrollers – especially in the U.S. – prefer a rules-based system, because if their their financial statements ever end up as a subject of a court or arbitration case, they can point to the specific rules they followed to calculate the figures, which created their financial statement. Rules-based accounting establishes a specific and verifiable procedure that is used when creating financial statements. On the negative side, the rules-based system can create needless complexities when readying fiscal statements.

Principles-based system: A principles-based accounting system is used as a conceptual footing for comptrollers and accountants. The principles-based accounting system aims to create guidelines – rather than rigorous rules - to help accountants create financial documents. Key to a principles-based accounting system is that this system allows for flexibility. A negative side of principles-based guidelines is that the information can be undependable or inconsistent – which leads to difficulties when a company compares its books and financial statements with those of other companies.

Without strict rules and procedures, documents prepared under a principles-based accounting system can lack consistency: revenue, net and gross income figures, and even calculations of projected revenues can vary widely.

Importance of the IFRS in Principles-Based Accounting

Of course, even in a more loosely regulated system, such as the principles-based accounting method, there needs to be specific criteria that will be consistent from company to company – and even within an entire industry – which often includes numerous countries. This is where the IFRS enters: It is a nonprofit foundation that sets criteria for principles-based accounting methods.

As the IFRS explains:

"Modern economies rely on cross-border transactions and the free flow of international capital. More than a third of all financial transactions occur across borders, and that number is expected to grow. Investors seek diversification and investment opportunities across the world, while companies raise capital, undertake transactions or have international operations and subsidiaries in multiple countries."

In the past, "cross-border" economic activity was complicated because different countries maintained their own sets of national accounting standards. "This patchwork of accounting requirements often added cost, complexity and ultimately risk both to companies preparing financial statements and investors and others using those financial statements to make economic decisions," the IFRS says. Companies in different countries often calculated, and reported, financial statements on different bases. The was a problem because even a small difference in requirements could have a major impact on a company’s reported financial performance and financial position.

The IFRS stepped in to establish criteria for principles-based accounting that created:

  • Accountability by reducing the information gap between the providers of capital and the people to whom they have entrusted their money. IFRS standards provide information that is needed to hold management to account. As a source of globally comparable information, IFRS standards are also of vital importance to regulators around the world.

A Model of Principles-Based vs. Rules-Based Standards

Even when IFRS standards are applied to principles-based accounting, this method is far too susceptible to the "abuse of discretion," according to a 2018 study conducted jointly by economists from The University of Chicago Booth School of Business and the NYU Stern School of Business. The study's authors found that in order to be accurate and effective, principles-based accounting can rely on the accounting manager’s professional judgement; otherwise, a strict rule should be applied, keeping it more more in line with rules-based accounting.

Since most global companies follow principles-based accounting, the study's authors, Pingyang Gao, Haresh Sapra, and Hao Xue, explain below:

"To get a favorable treatment, a transaction has to satisfy two hurdles: the evidence for the transaction must be sufficiently positive and the manager must also exercise professional judgement."

In other words, in a principle's based accounting system, companies, and their comptrollers and accountants, must rely not only on a loose set of criteria; they must also follow established rules, as they would in a rules-based accounting system. The IFRS, which as noted, has created and governs the criteria for a principles-based accounting system, actually agrees, to a point, when it states:


However, the U.S., and U.S. firms, are moving toward a principles-based accounting system – if for no other reason than the fact that most companies worldwide use it - including multinational corporations, many of which are based in the U.S. Using a principles-based accounting system, which is as reliable as a rules-based system merely involves applying rules to a principles-based system, says Remi Forgeas, CPA, in an article published on the FRSA website.

Applying Rules to a Principles-Based Accounting System

The simple answer to making a principles-based system more reliable is by providing rules for this method, just as there are in a rules-based system. According to the IFRS's Forgeas:

"In a principle-based accounting system, the areas of interpretation or discussion can be clarified by the standards-setting board (the IFRS), and provide fewer exceptions than a rules-based system. However, IFRS includes positions and guidance that can easily be considered as sets of rules instead of sets of principles. At the time of the IFRS adoption, this led English observers to comment that international standards were really rule-based compared, to the U.K. GAAP that were much more principle-based."

So, the principles-based system is really a rules-based accounting system, Forgeas notes. The difference is simply one of methodology and accounting treatment. "Under U.S. GAAP, the research is more focused on the literature whereas under IFRS, the review of the facts pattern is more thorough," Forgeas says.

Differences Between IFRS and U.S. GAAP

The true difference between a principles- and rules-based accounting system is really the difference between IFRS and GAAP standards. And those key difference, as Forgeas explains, are:

  • Consolidation: The IFRS favors a control model whereas U.S. GAAP prefers a risks-and-rewards model. 
  • Statement of Income: Under IFRS, extraordinary items are not segregated in the income statement, while, under U.S. GAAP, they are shown below the net income.
  • Inventory: Under IFRS, LIFO (a historical method of recording the value of inventory, a firm records the last units purchased as the first units sold) cannot be used while under U.S. GAAP, companies have the choice between LIFO and FIFO, which is a common method for recording the value of inventory.
  • Earning-per-Share: Under IFRS, the earning-per-share calculation does not average the individual interim period calculations, whereas under U.S. GAAP the computation averages the individual interim period incremental shares.
  • Development costs: These costs can be capitalized under IFRS if certain criteria are met, while it is considered as “expenses” under U.S. GAAP.

Too Many Rules vs. Professional Judgment

Rules-based accounting would seem to create a means of establishing an unambiguous decision-making method, but that can be deceptive. A rules-based accounting approach establishes series of bright lines that can allow those who prepare financial documents to game the system at the expense of the relevant principle. Too many rules restrict the ability of the comptroller or accountant to use her professional judgment. Having hundreds of pages of detailed rules leads to complexity, which can result in users focusing on the letter rather than the spirit of the standard.

Additionally, a rules-based approach creates a need for greater or more details, which arises due to both accountants and auditors seeking to minimize the risk of lawsuits. As noted, rule-based accounting his has made those who prepare financial statements believe that if rules are followed, it could exempt them from sanctions.

By contrast, principles-based accounting allows for the application of professional judgement of accountants as they assess the substance of any transaction and prepare financial documents. Principles-based accounting is very different from a check-box mentality. As Robert H. Herz, chairman of the FASB has noted, when accountants, auditors and standard setters apply reasonable amount of judgement, it is likely to enhance professionalism in financial statement reporting.

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