Introduction During the early 2000s, a number of major accounting scandals involving corporate giants such as Enron and WorldCom ignited a fierce debate about whether the U.S. should abandon the allegedly rules-based accounting system and adopt a principles-based system. Proponents of principles-based accounting blame the rules-based accounting system for these major accounting scandals. They believe that the rules-based system encourages the use of financial structuring to achieve desired accounting results, which will undermine the quality of financial reporting. Rules-based accounting puts the focus on compliance, rather than communication. Supporters of rules-based accounting argue that principles-based accounting relies heavily on judgment, which will reduce the consistency and comparability of financial information. As a reaction to the accounting scandals, the Congress enacted the Sarbanes-Oxley Act in 2002, of which former President George W. Bush regarded it as “the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” Section 108(d) of the Sarbanes-Oxley Act required the Securities and Exchange Commission (SEC) to conduct a study on the adoption by the United States financial reporting system of a principles-based accounting system. In 2002, the Financial Accounting Standards Board (FASB) issued a proposal, Principles-Based Approach to U.S. Standard Setting , in response to concerns about the quality and transparency of financial reporting in the U.S. In 2003, the SEC staff submitted its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (the SEC Study) to the Congress, making several recommendations to the FASB. Both the FASB and SEC believed that moving towards more objectives-oriented or principles-based standards was the future direction of accounting standard setting. The rules-based and principles-based accounting systems have their own merits and drawbacks - neither one is better than the other in all aspects. In recent years, the FASB has issued several standards that are more principles-based. The purpose of this paper is to examine which accounting system is more suitable to the U.S. The discussion is limited to the U.S. only because situations in other countries may be different from those in the U.S. Since there are different views on the meaning of the term “principles-based”, this paper will begin by discussing the definitions of “principles-based accounting” and “rules-based 1 accounting”, as well as their differences. Then I will discuss the evolution of U.S. Generally Accepted Accounting Principles (GAAP), examining the forces that drive U.S. GAAP towards more rules-based. The paper will compare the merits and drawbacks of the two accounting systems from the perspective of different stakeholders. I will provide arguments for why a principles-based accounting system is more suitable to the U.S. Finally, I will discuss the limitation of principles-based accounting and its remedies. Definitions of Rules-Based Accounting and Principles-Based Accounting Accounting standards under a rules-based system have three major characteristics. First, they provide a lot of exceptions that create situations in which the principles in the standards do not apply. There are three different types of exceptions – scope exceptions, application exceptions, and transition exceptions (FASB, 2002, 3). Scope exceptions allow the use of other existing accounting pronouncements to account for transactions and events that would otherwise be accounted for under the standards. Application exceptions allow the deviation from the principle of the standards and the use of alternative accounting treatments to account for certain transactions. This type of exception is provided to achieve a desired accounting result such as reducing the volatility of reporting earnings caused by the application of the principles in the standards. Transition exceptions are provided to alleviate the effects of transitioning to new accounting standards. This type of exception allows the use of the old rules to account for transactions occurred before the effective date of the new standards. Another characteristic of rules-based accounting standards is that they contain many bright-line tests. The bright-line tests are often provided to help determine whether a transaction or event falls under the exception rules. Rules-based standards are also characterized as containing a lot of detailed interpretive and implementation guidance. This guidance is often necessary because it describes the application of the exceptions. There are different views on the definition of principles-based accounting. A common view is that accounting standards under a principles-based accounting system are generally developed from a conceptual framework. They provide only general guidance on how to account for particular transactions. Management is required to exercise judgment and expertise when applying the accounting principles (Tribunella 2009, 33). 2 Some people view principles-based accounting the same as a principles-only approach. Principles-only accounting standards are defined as high-level standards with little or no operational guidance. Preparers of financial statements and auditors have to exercise judgment in accounting for transactions and events, but the standards do not provide a sufficient structure to frame the judgment (SEC, 2003). Therefore, similar transactions are accounted for differently across firms. People who hold such a view often oppose the adoption of principles-based accounting because the heavy reliance on judgment decreases comparability among reporting entities. In the SEC Study, the SEC staff provides a different definition for principles-based accounting, in which they refer it as an objective-oriented approach. Accounting standards under such an approach should have the following five characteristics: • Be based on an improved and consistently applied conceptual framework; • Clearly state the objective of the accounting standard; • Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis; • Minimize exceptions from the standard; • Avoid use of percentage tests (“bright-lines”) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard. (SEC, 2003) The objective-oriented approach seems to be an ideal approach of accounting standard setting, but in practice such an approach may be difficult to implement. “Sufficient detail” or “optimal level of detail” is a major characteristic of the objective-oriented approach; however, the words “sufficient” and “optimal” are ambiguous since the SEC does not specify how much detail constitutes “sufficient” and “optimal.” As illustrated in a later section, financial statement preparers and auditors always request more detailed guidance because they feel more comfortable with a certain and clear answer. The FASB must deal with the pressure from these constituents. In some cases, the FASB may have to concede and end up providing more than their interpretation of the “sufficient” amount of guidance. Lease accounting under U.S. GAAP and International Financial Reporting Standards (IFRS) best illustrates the differences between rules-based and principles-based accounting. U.S. 3 GAAP is usually considered rules-based, while IFRS is considered principles-based. Under U.S. GAAP, a lease is considered a capital lease if it meets any of the following four criteria: 1. The lease transfers ownership of the property to the lessee by the end of the lease term; 2. The lease contains a bargain purchase option; 3. The lease term is equal to 75 percent or more of the estimated economic life of the property; or 4. The present value of the minimum lease payments is equal to or greater than 90 percent of the fair value of the property. (Accounting Standards Codification Par. 840-10-25-1) These criteria are examples of bright-line tests, in which the third and fourth criteria contain strict percentage thresholds. In contrast, under IFRS, a lease is classified as a finance lease (equivalent to a capital lease under U.S. GAAP) if it transfers substantially all the risks and rewards incidental to ownership of an asset (IASB, IAS, par.8). The IASB also provides several examples and indicators of situations that individually or in combination may lead to a lease being classified as a finance lease (IASB, IAS, pars. 10-11). These examples and indicators are similar to the four criteria of classifying a lease as a capital lease under U.S. GAAP. However, the IASB does not provide any specified percentage in the examples related to the economic life of the asset and minimum lease payments. Instead it uses terms such as “substantially all” and “major part” which require the accountants to exercise judgment when interpreting these terms. In addition, before the codification of U.S. GAAP, the accounting literature for leases was composed of 16 FASB Statements and Interpretations, nine Technical Bulletins, and more than 30 EITF Issues (SEC, 2003). This large volume of interpretive and implementation guidance is one of the characteristics of rules-based accounting standards. Although U.S. GAAP is widely viewed as rules-based, it is actually a combination of rules-based, principles-based, and principles-only standards. Standards related to accounting