Why Consistency of Accounting Standards Matters − Normative Evi-

dence from the U. S. and Germany as Related to IFRS.*

1. Introduction

Ever since the occurrence of accounting scandals such as Enron in the beginning of
this century, the principles-versus-rules debate has been on the top of the agenda of securi-
ties regulators, especially of the U. S. Securities and Exchange Commission (SEC), and of
national and internal standard setters, such as the U. S. Financial Accounting Standards
Board (FASB), the International Accounting Standards Board (IASB) and the Institute of
Chartered Accountants of Scotland (SEC, 2003; FASB, 2002 and 2004; Tweedie, 2002 and
2005; ICAS, 2006a and 2006b). The topic is currently also one of the most controversially
discussed issues in national and international accounting reviews: Abacus and Accounting
Horizons have dedicated special issues to this debate (see Abacus, June 2006; Accounting
Horizons, March 2003).

The origins of the discussion go back to the early twentieth century. Until then, practi-
tioners in the U. S. have disapproved of the implementation of uniform accounting stan-
dards. They argued that the choice of accounting methods, which appropriately reflect the
economic substance of specific transactions and events, requires the use of professional
judgment (Previts and Merino, 1998, p. 163). However, with the proliferation of different
opinions about the proper accounting treatments and the crash of the U. S. stock market in
1929, there was a call for the establishment of uniform accounting standards that would
limit management’s use of professional judgment and enhance the comparability of finan-
cial statements (Previts and Merino, 1998, p. 161 et seqq.). Since then it has been widely
accepted that ‘[b]y articulating the best thinking about the issues, accounting standards will
produce better financial reporting, at least on the average, than would exist in their absence’
(Mason and Gibbins, 1991, p. 21). In the U. S. the call for comparability has, amongst
other things, led to what may be called an excessive overregulation (ICAS, 2006a, p. 5). As

* The paper was presented at the 3rd Workshop on Accounting in Europe at the ESSEC Business School in
2007 (Paris, France), at the 4th Workshop on Accounting and Regulation at the University of Siena in 2007
(Siena, Italy), in the Ph.D. program of the Area of Accounting & Taxation at the Center of Doctoral Studies
in Business in 2007 (Mannheim, Germany), at the Department of Accounting of the Stockholm School of
Economics in 2008 (Stockholm, Sweden) and at the 31st Annual Congress of the European Accounting
Association in 2008 (Rotterdam, Netherlands). The authors want to express their gratitude for helpful com-
ments on an earlier draft to David Alexander (University of Birmingham), Niclas Hellmann (Stockholm
School of Economics), Joachim Hennrichs (University of Cologne), Walter Schuster, (Stockholm School of
Economics), Kenth Skogsvik (Stockholm School of Economics) and Shyam Sunder (Yale University).
 –2–

a consequence of the corporate accounting scandals the accounting literature has disap-
proved of rules-based accounting and has increasingly called for a principles-based ap-
proach to standard setting (FASB, 2002; SEC, 2003; FASB, 2004).

Another topic that plays a major role in the planned reformation of the world’s pre-
vailing accounting regimes − IFRS and U. S. GAAP − is the elimination of inconsistencies
and thus the quest for internal consistency of the respective regimes (IASB, 2006, P3 and
BC.52−BC.54). The accounting literature distinguishes between two notions of consistency
− internal consistency of accounting standards on the one hand and consistency in the
application of the accounting standards on the other hand. While internal consistency re-
quires that ‘any individual standard adopted should be consistent with the existing system
of standards’ (ASBJ, 2004) consistency in the application ‘refers to use of the same ac-
counting policies and procedures, either from period to period within an entity or in a sin-
gle period across entities’ (IASB, 2006, QC35).

Internal consistency as well as the consistency in the application of accounting stan-

dards across companies has traditionally been aimed at in all major accounting regimes.
Interestingly, the reasons for the pursuance of this objective are quite different in different
regimes. The FASB highlights in Concepts Statements No. 2 that the U.S. Conceptual
Framework ‘is a coherent system of interrelated objectives and fundamentals that is ex-
pected to lead to consistent standards’ and emphasizes the need for a cross-firm consistent
choice of accounting policies by stating that ‘[t]he public is naturally skeptical about the
reliability of financial reporting if two enterprises account differently for the same eco-
nomic phenomena’ (CON 2.16). It explains the need for consistency in relation to compa-
rability: Comparability between enterprises and consistency in the application of methods
over time increases the informational value of comparisons of relative economic opportu-
nities or performance’ (CON 2.111). In their draft for a revised conceptual framework the
FASB and the IASB similarly point out that ‘[p]ermitting alternative accounting methods
for the same transactions or other events […] is undesirable because to do so diminishes
comparability …’ (IASB, 2006, QC38). Also in the EU, the adoption of a single set of fi-
nancial reporting standards (IFRS) is reasoned with the enhancement of the comparability
of financial statements of publicly listed companies (rationale 1 IAS Regulation). Current
efforts aiming at ensuring a consistent application of IFRS, such as the coordination of
national enforcement actions by the Committee of European Securities Regulators (CESR)
 –3–

and the establishment of a roundtable addressing the consistent application of IFRS1, un-
derpin the importance of consistency in the EU.

By contrast, the necessity for German accounting principles (“Grundsätze ord-

nungsmäßiger Buchführung” − GoB) to be internally consistent results from the constitu-
tional postulate of justice (“Gerechtigkeitsgebot”) and the equality principle (“Gleichheits-
grundsatz”) according to which the same matters need to treated identically and different
matters ought to be treated differently (Canaris, 1983a, p. 16). In Japan, internal consis-
tency of accounting standards is required in order to achieve stable order (ASBJ, 2004).
The Accounting Standards Board of Japan further justifies the need for consistency by
arguing that if existing standards are regarded to result in relevant information and if a
standard dealing with a so far unregulated transaction or event is developed consistently
with existing standards the new standard typically also leads to relevant information in an
unchanged economic environment (ASBJ, 2004).

We observe that the two ‘notions’ of consistency are related in such a way that consis-
tency in the application of accounting standards across companies can only be achieved if
the accounting standards are internally consistent: In a regime that provides clear rules for
each and every accounting issue and in which the application of the rules does not require
the use of any judgment, internal consistency between the rules would not be required be-
cause consistency in the application across companies would be achieved anyway (AAA
FASC, 2003, p. 74). However, such a system does not exist in reality. The continuous issu-
ance of new accounting standards and interpretations in rules-based regimes, such as U.S.
GAAP, reveals that there are always issues not covered by any rule as well as rules the ap-
plication of which requires management to use judgment. In more principles-based regimes
the application of the high-level principles to specific accounting issues demands the exer-
tion of judgment in virtually all cases.

In particular, judgment is necessary either if a transaction or event is not covered by

any accounting standard or if it is only addressed by a rather broad principle. In such cases
management shall typically develop an accounting policy/interpret the vague principle by
reference to the requirements and guidance in standards dealing with similar and related
issues (see e.g. IAS 8.11 (a)). If the standards addressing similar transactions or events are

1See for details

http://ec.europa.eu/internal_market/accounting/docs/ias/roundtable/060220_roundtable_en.pdf (accessed
on 16 April 2008).
 –4–

not consistent with each other, different companies may make different interpretations and
choices and thus apply different accounting policies to identical cases.

The IASB, much more than the FASB, now aims at moving from a rather rules-based
to a more principles-based approach to standard setting by reducing guidance dealing with
specific recognition and measurement issues, thereby increasing the use of professional
judgment (Tweedie, 2002). Also in such a principles-based approach to standard setting
internal consistency of accounting standards is regarded as desirable (IASB, 2006, BC2.54).
The difference with regard to more rules-based regimes is that the internal consistency of
the principles shall only frame management’s judgment, but it shall not necessitate the use
of one specific accounting method (ICAS, 2006a, p. 14). The lack of specific guidance in
principles-based regimes leads to the fact that companies may, even if the accounting stan-
dards are internally consistent, exert judgment differently and thus apply the high level
principles inconsistently to identical transactions and events (SEC, 2003, I.C.). Those sup-
porting principles-based accounting standards argue that the restriction of management’s
judgment that follows from the objective to achieve a consistent application may some-
times impair the relevance of financial reporting information, which they regard to be more
important than consistency and comparability (Alexander and Jermakowicz, 2006, p. 150).

It becomes obvious that the rules-versus-principles debate and the discussion on con-
sistency are immediately related. In our paper, we contribute to this debate by addressing
two major issues: In the first instance, we take the traditional quest for consistency in the
application of accounting standards as given and analyze how the current IFRS regime
would have to be changed with regard to internal consistency of accounting standards as
well as to the relationship between principles and rules in order to achieve consistent appli-
cation. The emphasis of our analysis will be on present and possible future IFRS account-
ing regimes, but we also refer to U. S. GAAP because most of the arguments brought for-
ward in the comprehensive U. S. accounting literature equally apply to IFRS. The U. S.
securities regulation and its corporate governance regimes have been characterized as para-
digmatic for regulatory approaches of a ‘case-law system’ (La Porta, Lopez-de-Silanes,
Shleifer and Vishny, 1998; La Porta, Lopez-de-Silanes and Shleifer, 1999). We choose the
German accounting regulation as a second reference for the comparison with IFRS since it
has been referred to as being paradigmatic for the opposite type of regulatory approach
called ‘code-law systems’ (or ‘civil-law systems’). A final reason – besides the obvious fa-
miliarity of the authors with this system – is because it has, just as the U. S., a prominent
tradition of normative accounting thought (Küpper and Mattessich, 2005).
 –5–

The second major research question that we address is whether the benefits of princi-
ples-based accounting standards, such as an increase in relevance, outweigh the loss of con-
sistency in the application. For this discussion, we loosen our previous assumption that a
consistent application of accounting standards by all companies is requested and critically
discuss and balance the advantages and disadvantages of principles-based and rules-based
accounting standards. We come to the conclusion that for reasons of comparability, en-
forceability and objectivity of financial reporting information it is important to have spe-
cific (internally consistent) accounting requirements that limit management‘s judgment in
the application of accounting standards to ideally only one possible accounting treatment.
We acknowledge, however, that this may, in some situations, lead to an impaired relevance
of financial reporting information.

2. Towards Consistency in Normative Accounting Frameworks

In this part we show how the quest for internal consistency has developed in different
accounting regimes and how it is sought to be achieved in the respective standard setting
process (accounting-law-making process). We conclude that a consistent application of
accounting standards does not only presuppose the existence of internal consistency of
high-level concepts and principles, but also that the rule maker (and management in the
absence of specific guidance) trades-off between and applies the concepts and principles
consistently to all comparable accounting issues. We infer from this that in an internally
consistent accounting regime there is, in principle, for each transaction and event only one
accounting treatment that accords to the high-level concepts and principles as well as to the
specific guidance relating to comparable accounting issues and thus consistently fits into
the entire ‘system’.

The Quest for Consistency in the U. S.

Since the beginning of the twentieth century academics in the U. S. have continuously
been calling and searching for a theoretical foundation of financial reporting (Archer, 1992;
Storey, 2003). Storey (2003) attributes this trend to the desired reduction of acceptable ac-
counting treatments, or, more specifically, to the aimed elimination of unsound accounting
treatments and the enhancement of comparability between financial statements. Hendrik-
sen and van Breda (1992) point out that a common conceptual framework was expected to
help reconciling Board members’ differing opinions about appropriate accounting treat-
ments and thus to facilitate the standard setting process (p. 61; see also Gellein, 1986,
p. 13).
 –6–

At the outset, accounting principles had been derived inductively from the accounting
practice in the U. S. For example, Sanders, Hatfield and Moore developed their ‘A State-
ment of Accounting Principles’ (1938) by surveying and collecting the current accounting
practice, but they did not provide a systematic theoretical foundation. At that time, ‘consis-
tency’ meant consistent application of the chosen accounting policies over several periods
rather than internal consistency of the entire set of accounting principles or application of
the same accounting methods to identical cases by all enterprises (Storey, 2003, p. 23; May,
1943, p. 80; Wüstemann, 1999).

Later, academics such as Paton and Littleton (1965) presented a theoretical framework
in the form of postulates and basic assumptions, which they self-perceived as a ‘coherent,
coordinated, and consistent body of doctrine’, with the aim to explain and justify the pre-
vailing accounting practice and to suggest improvements to it (Preface, p. viii). Ijiri (1967)
also took the conventional accounting system, especially historical cost valuation, as given.
But, in contrast to Sanders, Hatfield and Moore, he sought to logically structure the
prevailing accounting practice by means of axioms.

In the 1960s, with the beginning of the ‘a priori research’, the desirability of internal
consistency of accounting principles was widely accepted: Instead of deriving principles
from the prevailing practice, researchers, such as Chambers (1966), Edwards and Bell
(1961) and Sprouse and Moonitz (1962), established consistent theoretical frameworks
independently from the accounting practice and, on this basis, deduced consequential ac-
counting principles (Haller, 1994, p. 94). According to Hendriksen and van Breda (1992)
the normative accounting theorists ‘attempt[ed] to prescribe what data ought to be com-
municated and how they ought to be presented; that is, they attempt[ed] to explain what
should be rather than what is’ (p. 17).

Smith as early as 1912 argued that ‘accounting is, or ought to be, a science, […], ame-
nable to definite axioms and capable, in proper practice, of producing definite and exact
results’ (p. 112, quoted from Previts and Merino, 1979, p. 162). Ijiri (1967) seems to have
had the same understanding of consistency in accounting: In analogy to the Euclidean ge-
ometry, he established a set of axioms, which was supposed to permit application of the
valuation rules ‘in a purely mathematical way without making any empirical judgment’
(p. 88). This may be regarded as a late reflex of Samuelson’s re-calibration of economics in
his seminal work of 1947 (Samuelson, 1983, p. XVII et seqq.).

By contrast, the U. S. Supreme Court has, with good reasons, stated that ‘financial ac-
counting is not a science’ (Shalala v. Guernsey Memorial Hospital, 514 U. S. 87, 1995).
 –7–

Nolan (1972) holds that accounting is different from natural sciences because ‘[t]here is no
“right” way of proceeding’ (p. 18). Hendriksen and van Breda (1992) agree by highlighting
that ‘[a]ccounting systems are not purely abstract structures, nor is the debate over account-
ing rules purely theoretical in the sense of being without practical significance’ (p. 112) and
that an axiomatic or mathematical approach ‘is too far removed from reality to be able to
derive realistic and workable principles or to provide a basis for practical rules’ (p. 16). In
conformity with this, one may argue that Hausman’s (1992) statement that economics is an
‘inexact science’ also applies to accounting (p. 205 et seqq.). This debate somewhat imports
elements of the former controversy on the possibility of the value-free social sciences
(‘Werturteilsstreit’) into accounting theory and practices (Blaug, 1992, p. 112-24; Weber,
1949, p. 20-21; see on value judgments in accounting Moxter, 2003, p. 9).

The Impact of the Desired Consistency on U. S. Standard Setting

The U. S. Conceptual Framework, which is designed as ‘a coherent system of interre-

lated objectives and fundamentals that ought to lead to consistent standards’, takes this into
account by emphasizing that ‘it is not expected automatically to provide ready-made,
unique, and obviously logical answers to complex financial accounting or reporting prob-
lems’ (Hendriksen and van Breda, 1992, p. 60); rather, the stated objectives and concepts
shall provide ‘the Board with a common foundation and basic reasoning on which to con-
sider merits of alternatives’ (Preface to ‘Statements of Financial Accounting Concepts’).
This means that depending on how much weight the Board members attach to the differ-
ent concepts and principles in the framework (FASB CON 2.10) they can come to differ-
ent conclusion as regards the choice of appropriate accounting treatments. In this context,
Hendriksen and van Breda (1992) note that ‘the results depend significantly on those who
use the concepts to establish accounting standards’ (p. 62). It should however be noted that
the Conceptual Framework does not allow an arbitrary use of judgment, but rather limits
the Board members’ and management’s judgment to a small number of different interpre-
tations.

The Rationale for Consistency in Germany

German accounting principles form part of the German legal body. As a consequence
of their legal quality, German accounting principles are required to be in conformity with
the German legal system. It follows from the above mentioned constitutional postulate of
justice and the equality principle that German accounting principles, shall be internally con-
sistent (Canaris, 1983a, p. 16-19).
 –8–

Beisse (1990) describes and, in the same instant, prescribes German principles of or-
derly accounting (‘Grundsätze ordnungsmäßiger Buchführung’ − GoB) as an ‘all-
embracing and coherent structure of general principles and individual norms’ (p. 500).
Since the individual accounting norms are consistently derived from the dominating high-
level principles, German GoB are indisputably regarded as ‘principles-based’ (Beisse, 1990,
p. 499-500).

Even though statutory provisions do not exist for each and every issue, German GoB
are in principle without gaps (Canaris, 1983b; Beisse, 1990, p. 499; see for civil law legal
systems in general David and Brierley, 1978, p. 335). For the German accounting regime
this means that, in the absence of a written (codified) or an unwritten norm (having been
developed by the courts) applicable to a certain transaction or event, the corresponding
norm needs to be revealed within the system by an application and interpretation of the
existing high-level principles (Beisse, 1990, p. 502-03; see for accounting regimes embed-
ded in code/civil law jurisdictions Accounting Standards Board of Japan, 2004, par. 13−16;
see for civil law legal systems in general David and Brierley, 1978, p. 335 and 360-61;).

The Impact of the Required Consistency on Accounting Law Making in Germany

It is now widely acknowledged that a formal-logic or axiomatic-deductive derivation of

legal (accounting) norms is impossible (Canaris, 1983a, p. 25-29; Euler, 1996, p. 23 et
seqq.). Rather, accounting norms shall be derived by means of the teleological method
(Beisse, 1984, p. 12; Moxter, 2003, p. 15-16). This approach requires first to comprehend
the legislator’s value judgments (‘gesetzliche Wertung’); then, the high-level principles are
to be interpreted in accordance with their (statutorily) intended purpose; finally, they shall
be consistently applied to the specific cases (Canaris, 1983, p. 20-25; Euler, 1996, p. 11-14;
Engisch, 2005, p. 88 et seqq.). Due to the required consistent application of the high-level
principles to specific cases, there is for each case in principle only one accounting treatment
that meets the statutory value judgments and thus consistently fits into the entire account-
ing system.

Discussion

U. S. GAAP, German GAAP (GoB) and also IFRS all require the use of judgment in
the application of accounting standards/norms. German GoB require courts and therefore,
ultimately, managers to use judgment in revealing the ‘one’ accounting norm that conforms
to the legislator’s value judgment and therefore consistently fits into the system. This presup-
poses a consistent balancing between and application of the high-level principles to all
 –9–

comparable accounting issues, for instances to all revenue-generating transactions and

events. By contrast, Board members and managers under U. S. GAAP and IFRS are sup-
posed to balance between and apply the general concepts to specific cases according to
their personal professional judgment (see e.g. IASB FW.45), which may differ from case to case.
This implies that for some issues there may be several different accounting methods that
are all in compliance with the framework and between which the Board members or man-
agement may hence choose.

Consistent application postulates that comparable issues are accounted for in the same
way across companies (Schipper, 2003, p. 62). We argue that this can only be achieved if
standard setters (and managers in the absence of clear guidance) trade-off between and
apply the general concepts, such as relevance and reliability, as well as the general recogni-
tion and measurement principles consistently to all comparable cases. In an internally con-
sistent accounting regime there can hence for each accounting issue only be one accounting
treatment that accords to the high-level concepts principles as well as to the specific guid-
ance relating to comparable accounting issues.

Impossibility of Consistency

Alexander and Jermakowicz (2006) point out that accounting ‘is most certainly not a
pure science’ and conclude that ‘[i]nternal consistency, as an absolute, is simply not possi-
ble’ (p. 150). In another article Alexander (2006) claims that companies in different coun-
tries will apply IFRS inconsistently in identical cases and that the enforcement of account-
ing regulation must accept this (p. 75). We agree that accounting is not a ‘pure science’ (see
supra) and that ‘absolute’ consistency of all accounting principles is not achievable. Indis-
putably, one can also agree with Alexander’s assumption that IFRS will never be inter-
preted and applied fully consistent by all companies. However, just as in the case of other
ideals, such as justice, equality and freedom, the impossibility to achieve internal consis-
tency in absolute terms does, from a normative perspective, not imply that consistency
between accounting norms and their consistent application in identical cases is not desir-
able and should not be aimed at. It neither implies that on a comparative basis there cannot
be more consistent and less consistent accounting norms.

3. The Role of Consistency in the IFRS Regime

In this part we explore in how far internal consistency is achieved in the IFRS regime. We
find that the IASB Framework contains contradictory objectives and qualitative character-
 – 10 –

istics as well as conflicting general concepts and principles. As a result Standards and Inter-
pretations dealing with similar and related issues are partly inconsistent. We draw from this
finding that a consistent application of IFRS is currently not ensured. Finally, we present
the IASB’s efforts towards the elimination of the described inconsistencies.

The Qualitative Characteristics ‘Relevance’ and ‘Reliability’

Also the IASB strives for consistency of its standards: According to the Preface to In-
ternational Financial Reporting Standards ‘[t]he objective of the Framework is to facilitate
the consistent and logical formulation of IFRSs’ (para. 8). Moreover, in their proposal of a
revised conceptual framework the FASB and the IASB note that ‘internal consistency of
accounting standards is desirable and that it should naturally result from developing stan-
dards that are consistent with the same conceptual framework’ (IASB, 2006, BC2.54). Just
as the U. S. Conceptual Framework the IASB Framework points out that the Board mem-
bers in the standard setting process and managers when developing accounting policies for
unregulated issues need to trade-off between the qualitative characteristics, especially rele-
vance and reliability (FW.45). However, at present, there is neither unanimous agreement
on what constitutes relevant and reliable information nor on how to adequately trade-off
between the two qualitative characteristics (Johnson, 2005, p. 1; Joyce, Libby and Sunder,
1982; Kirk, 1989, p. 91; Loftus, 2003, p. 303-04; Mozes, 1998, p. 152-53). Whether an ac-
counting method provides relevant information depends, amongst other things, on the
objective of financial statements and the underlying explicit or implicit accounting theory.
If, as according to Sprouse and Moonitz (1962), the objective of financial statements is to
provide information about the financial position and changes in the financial position of an
enterprise, information about the enterprise’s wealth as indicated by its resources (assets)
and obligations (liabilities) are considered as relevant (assets/liabilities view) (Sprouse and
Moonitz, 1962, p. 11-12; see also Johnson, 2004, p. 1)2. If, as according to Paton and Little-
ton (1965), the objective of financial statements is to provide information about the per-
formance of an enterprise, information about the enterprise’s efficiency in obtaining inputs
to produce and sell outputs as indicated by net periodic profit is regarded as relevant (reve-
nue/expense view) (p. 10; see also FW.69; FASB, 1976, p. 39). The differences of the two
objectives and the related accounting theories as well as the impossibility to pursue both at
the same time has been evidenced in the German literature on accounting theory since the

2 This follows from the definition of financial position in the Glossary as ‘[t]he relationship of the assets,
liabilities and equity of an entity, as reported in the balance sheet’.
 – 11 –

1920ies (see e.g. Schmalenbach, 1926, p. 80 et seqq.; Moxter, 1984; see also Benston,
Bromwich and Wagenhofer, 2006, p. 171-76).

The existing IASB Framework contains both opposing and inconsistent objectives
(FW.15; IAS 1.7). As a consequence standards contain recognition and measurement prin-
ciples that reflect different accounting theories and are thus sometimes inconsistent. The
following example shall illustrate the resulting inconsistencies: The IASB has given priority
to the revenue/expense view in the recognition of government grants, since the corre-
sponding income shall be allocated over the periods necessary to match them with the re-
lated costs (IAS 20.12) (see for the incompatibility of IAS 20 with the assets/liabilities view
Nobes, 2004, p. 30). By contrast, in the case of biological assets the IASB has given priority
to the assets/liabilities view because income shall be recognised independently from the
incurrence of the costs when an increase in wealth (indicated by an increases in the asset’s
fair value) has taken place (IAS 41.12 and 41.26).

Furthermore, the existing IASB Framework does not ‘convey[.] the meaning of reli-
ability clear enough to avoid misunderstandings’ (IASB, 2006, BC2.13). The IASB (2005a)
notes that

[f]or many [Board members], the meaning seems to be verifiability, for some its preci-
sion, for some, it may be faithful representation, for a few perhaps all of those plus
neutrality. Among constituents, the differences in meaning are if anything much
greater (para. 41; see also Johnson, 2005, p. 1-2).

In case that the qualitative characteristics ‘relevance’ and ‘reliability’ suggest different
accounting policies, the IASB in the standard setting process, and management in the de-
velopment of accounting policies when no IFRS addresses the particular transaction or
event, need to trade-off between the two qualitative characteristics (FW.45). The IASB
Framework does not provide guidance on how to balance between ‘relevance’ and ‘reliabil-
ity’, but rather requires management itself to find an appropriate balance between the char-
acteristics by using its professional judgment (FW.45). In the absence of legal liability this
may be tolerable. Given the threat of different assessments in court this imposes an unde-
sirable risk on management even if assessment and application is done in good faith.

The FASB points out that ‘no consensus can be expected about their relative impor-
tance in a specific situation because different users have or perceive themselves to have
different needs and, therefore, have different preferences’ (FASB CON 2.45). The diverg-
ing opinions about the relative importance of ‘relevance’ and ‘reliability’ in the accounting
literature confirm this statement. For example, Ernst & Young (2005) regard reliability as ‘a
necessary precondition that must be met for information to be relevant’ (p. 2). By contrast,
 – 12 –

Chambers (1996) argues in the context of measurement that the qualitative characteristics
are mutually exclusive and that a trade-off results in information that is neither relevant nor
neutral (reliable) (p. 127).

Joyce, Libby and Sunder (1982) evidence the low agreement on the meaning and the
relative importance of the qualitative characteristics by means of an experiment, which,
they claim, results in users choosing different accounting policies in identical situations.
According to Joyce, Libby and Sunder (1982) ‘[t]his casts doubt on the ability of the quali-
tative characteristics […] to facilitate accounting policy making’ (p. 670). One may con-
clude from these findings that the qualitative characteristics ‘relevance’ and ‘reliability’ do
not enable Board members as well as managers in the absence of clear guidance to consis-
tently exercise their professional judgment in the development and application of account-
ing policies relating to comparable issues.

The General Definitions, Recognition Criteria and Measurement Concepts

Solomons (1986, p. 120-21) and Dopuch and Sunder (1980, p. 6-7) demonstrate by
reference to pension obligations and deferred taxes that the liability definition under U. S.
GAAP is too broad to be helpful in choosing between different accounting policies. This
criticism also applies to the largely comparable liability definition and other financial state-
ment elements definitions in the IASB Framework (FW.60). For example, according to
FW.70(a) income arises from inflows or increases of assets or decreases of liabilities. How-
ever, only some increases of assets, such as increases in the fair value of certain financial
instruments (IAS 39.55(a)) and biological assets (IAS 41.26), give rise to income, while oth-
ers, such as increases in the fair value of available-for-sale financial assets (IAS 39.55(b))
and increases in the carrying amount of property, plant and equipment (IAS 16.39) and
intangible assets (IAS 38.85) resulting from a revaluation, are credited directly to equity and
thus do not give rise to income. The fact that the IASB has more or less arbitrarily drawn
the line between unrealized increases in assets that are recognized through profit and loss
and unrealized asset increases excluded from income (IASB, 2005a, p. 11) reveals that the
income definition in the IASB Framework is too broad to limit (arbitrary) choices in the
development of accounting policies, either by the Board or by preparers.

The same can be said about the general recognition criteria in the IASB Framework,
the probable inflow of future economic benefits associated with an item and its reliable
measurement (FW.83). The IASB Framework does not provide any threshold that must be
met for the inflow of economic benefits to be regarded as probable. In view of the vague-
ness of the probability criterion, it is not surprising that the IASB has set different prob-
 – 13 –

ability requirements for different accounting issues, as evidenced above for the recognition
of revenue from the sale of goods and construction contracts. As regards the reliable
measurement criterion, the IASB (2005a) has observed that the ‘accounting standards have
different (inconsistent?) hurdles for sufficiently reliable measurement and different (incon-
sistent?) treatments for insufficiently reliable measurement’ (p. 11). It follows that the gen-
eral recognition criteria in the IASB Framework do not provide a suitable basis for the
consistent deduction of accounting policies in the absence of an IFRS.

Instead of providing guidance on how to find an appropriate measurement attribute in

a specific situation, the IASB Framework only lists several measurement bases that are used
in the accounting practice (FW.100) (IASB, 2005d, p. 20). Due to the ‘lack of an agreed,
coherent measurement theory’ inconsistencies in the measurement of financial statement
elements exist in several IFRS, such as in IAS 39, which is deemed to ‘reflect more or less
arbitrary mixed measurement compromises pending resolution of conflicting views on ap-
propriate measurement bases’ (IASB, 2005d, p. 20). This suggests that the required refer-
ence to the Framework’s measurement concepts in the absence of an IFRS dealing with a
specific issue or with related issues does not adequately guide management’s judgment in
the choice of a measurement attribute.

Standards and Interpretations Dealing with Similar and Related Issues

Since the IASB has not applied the IASB Framework’s general recognition and meas-
urement principles consistently to similar issues, some IFRS are inconsistent. For example,
revenue from the sale of goods shall not be recognized until the seller has transferred the
significant risks and rewards of ownership to the buyer (IAS 18.14(a)). This typically occurs
with the transfer of legal title or the passing of possession to the buyer (IAS 18.15). If the
‘risks and rewards criterion’ was also applied to construction contracts, revenue would gen-
erally have to be recognized when construction is complete. It has been argued that in the
case of long-term construction contracts, the ‘completed contract method’ would not ap-
propriately reflect the enterprise’s performance during the periods of construction (IFRIC,
2006, p. 4; Paton and Littleton, 1965, p. 50). Therefore, the IASB makes an exception from
the ‘risks and rewards criterion’ in the case of construction contracts: If the outcome of the
contract is reliably measurable IAS 11.22 requires revenue from construction contracts to
be recognized according to the stage of completion of contract activity at each balance
sheet date, even if the enterprise has not yet transferred legal title or possession to the cus-
tomer.
 – 14 –

The IASB’s Efforts towards the Elimination of Inconsistencies

Having recognized that the objectives, concepts and principles in the existing IASB
Framework are partly ambiguous and internally inconsistent, the IASB and the FASB have
started a joint project on the revision and convergence of their conceptual frameworks in
2004. The objective of the project is to develop a common conceptual framework that is
‘sound, comprehensive, and internally consistent’ and thus constitutes an adequate founda-
tion for the development of consistent, principles-based accounting standards (IASB, 2006,
P3; Bullen and Crook, 2005, p. 1).

One measure that the Boards plan to undertake in respect of the existence of conflict-
ing objectives and accounting theories is to place greater emphasis on providing informa-
tion on an enterprise’s financial position and thus the assets/liabilities view: According to
chapter 1 of the [Draft] Conceptual Framework for Financial Reporting the objective of
financial statements shall ‘only’ be to ‘provide information about the economic resources
of the entity (its assets) and the claims on those resources (its liabilities and equity)’, i.e. its
financial position (IASB, 2006, OB18). The draft conceptual framework further states that
information about an entity’s financial performance is also essential (IASB, 2006, OB18
and OB22). However, since the term ‘performance’ is planned to be defined in terms of
changes in the entity’s financial position, it appears as if the depiction of an enterprise’s
performance in the original sense (e.g. according to Paton and Littleton, 1965) shall no
longer be a distinct objective of IFRS financial statements, from which consequential rec-
ognition and measurement criteria (such as the stage-of-completion method in IAS 11) are
developed.

Apart from this, the Boards intend to replace the term ‘reliability’ by the term ‘faithful
representation’ in order to clarify its meaning (IASB, 2006, QC16; IASB, 2006, BC2.26-
BC2.29); the currently required trade-off between ‘relevance’ and ‘reliability’ shall be substi-
tuted by a flow process (IASB, 2005b, para. 3-4), in which the standard setter or, in the
absence of an IFRS, management should first identify the economic phenomena that are
relevant in making economic decisions and then choose the recognition and measurement
methods the application of which provides the most relevant information (IASB, 2006,
QC43; IASB, 2005c, para. 9-22) and then assess whether the chosen accounting method is
a sufficiently faithful representation of the respective economic phenomena (IASB, 2006,
QC43).

In order to remove existing measurement inconsistencies the IASB is currently under-

taking a project on measurement objectives. In line with the SEC’s notion that the adop-
 – 15 –

tion of principles-based standards will probably lead to an increasing employment of fair

value (SEC, 2003, III.I.i.) the IASB tentatively concluded that fair value is the most desir-
able measurement basis on initial recognition (IASB, 2005d, p. 13). In theory, the adoption
of fair value as a single measurement attribute would lead to consistency since ‘the fair
value of any particular asset or liability is the same for every entity’ (Barth, 2006, p. 3-4).
Anyhow, in practice the use of valuation methods in the absence of market prices which
require management to make estimates renders it most unlikely that companies calculate
the same values in identical circumstances. This implies that internal consistency of ac-
counting standards, for example as regards measurement, does not automatically guarantee
a consistent application of the respective standards. Benston, Bromwich and Wagenhofer
(2006) therefore argue that standard setters need to provide ‘very detailed rules for calculat-
ing’ fair values (p. 173). This is, however, not in line with the current trend in standard set-
ting to move from rules-based to more principles-based accounting standards.

4. The Move from Rules-based to Principles-based Accounting Standards

In the following part we make the link between the consistency issue and the rules-
versus-principles debate in the accounting literature. We first work out the definitions, dis-
tinctive characteristics of rules and principles based on the legal literature and the account-
ing literature. In this context, we come to the conclusion that the removal of many of the
deficiencies currently perceived in relation to the rules under U.S. GAAP and IFRS does
not require a complete elimination of rules, but could also be achieved by a removal of
present inconsistencies. Moreover, we demonstrate that a consistent application of ac-
counting standards does not only presuppose internal consistency of the accounting stan-
dards, but also the provision of rules in the form of specific recognition and measurement
requirements.

The Definition of Rules and Principles in the International Legal Literature

The distinction of principles from rules and the respective advantages and disadvan-
tages have already been exhaustively debated by prominent legal scholars. Since the defini-
tions from the legal literature shed light on the understanding of principles and rules in the
internal accounting debate, they will be presented in the following and thereby integrated
into the accounting debate.

Most legal scholars, such as Dworkin, Hart, Raz and Braithwaite, differentiate between
rules and principles by reference to their degree of specificity (Dworkin, 1967; Hart, 1994,
 – 16 –

p. 260; Raz, 1972, p. 838; Braithwaite, 2002, p. 47). Principles are in this regard generally
considered as vague prescriptions (Braithwaite, 2002, p. 1). According to Dworkin (1967), a
principle ‘states a reason that argues into one direction, but does not necessitate a particular
decision’ (p. 26). Raz notes that principles ‘do not dictate consideration to be taken into
account, but merely limit the range of the considerations’ (Raz, 1972, p. 846). In confor-
mity with Dworkin and Raz, Cunningham (2007) attributes the characterization of princi-
ples as vague to the fact that they offer little ex-ante guidance and that they require the
actors to exercise judgment in the application of the principles to particular cases (p. 11).
By contrast, rules are regarded as specific prescriptions (Braithwaite, 2002, p. 1). Dworkin
(1967) describes rules to be ‘applicable in an all-or-nothing fashion’, i.e. ‘[i]f the facts a rule
stipulates are given, then either the rule is valid, in which case the answer it supplies must
be accepted, or it is not, in which case it contributes nothing to the decision (p. 25). If fol-
lows from Cunningham’s (2007) comparative analysis of rules and principles that, due to
their specificity, rules provide more ex-ante guidance and leave only little room for the use
of professional judgment (p. 11).

The Definition of Rules and Principles in the Accounting Literature

In conformity with the legal literature, the accounting literature also distinguishes be-
tween rules and principles by reference to their specificity and the degree of judgment that
is required in their application: While the SEC, the Institute of Chartered Accountants of
Scotland (ICAS) and most researchers characterize rules as being highly detailed and un-
ambiguously prescribing specific accounting treatments (SEC, 2003, I.D.; Kivi, Smith and
Wagner, 2004, p. 11; ICAS, 2006b, p. 8 and 10; see also Mason and Gibbins, 1991, p. 22),
principles are typically described as broad guidelines that, instead of providing detailed im-
plementation guidance, require preparers to exercise judgment in applying the principles to
specific transactions and events (Tweedie, 2002 and 2005, p. 33-34; see also SEC, 2003,
para. I.C.).

Tweedie (2002) points out that in an accounting regime that is based on principles only
many individual transactions and events are not explicitly dealt with in any standard. In
such cases, management is supposed to select and apply appropriate accounting policies by
exercising professional judgment. Dickey and Scanlon (2006) further note that in a princi-
ples-based regime enforcing agencies are only allowed to second-guess management’s pro-
fessional judgment if the selected accounting policies are not in conformity with the high-
level principles or if the judgment was not made ‘in good faith’ (p. 16-17; see also Ng,
2004, p. 20). They conclude that ‘[t]he “principles-based” approach theoretically permits
 – 17 –

public companies to have differing accounting judgments within the framework of these
broad principles’ (Dickey and Scanlon, 2006, p. 13; see also Coglianese et al., 2004, p. 38;
Kivi, Smith and Wagner, 2004, p. 12).

It seems as if the definition of principles and rules in the accounting literature is very
much in line with the one in the legal literature. However, there are also remarkable differ-
ences: In addition to the characteristics named above the SEC and some others additionally
characterize accounting rules as containing quantitative thresholds (bright-line tests), scope
exceptions and inconsistencies, while they consider accounting principles as eschewing
exceptions and as being devoid of bright-lines (I.C.; FASB, see also Bonham et al., 2008,
p. 74). Others in the accounting literature further note that principles are derived from a
complete and internally consistent conceptual framework (Bonham et al., 2008, p. 74; Choi
and McCarthy 2003, p. 6; IASB, 2006, P3; ICAS, 2006a, p. 1).

When comparing those additional characteristics with the legal definition of principles
and rules we remark that those characteristics represent distinct attributes of principles and
rules in the accounting literature, but that they do not form part of the respective legal
definitions. In fact, the characterization of rules in the accounting literature represents a
description of the perceived deficiencies of current U. S. GAAP and the characterization of
principles represents a description of what the accounting literature regards as desirable.
This may explain why rules have become quite unpopular and why standard setters and
accountancy bodies, such as the IASB and the Institute of Chartered Accountants (ICAS),
and the international accounting literature so intensely call for principles.

If one refers to the definition of rules in the legal literature rules must not necessarily
contain bright-line tests, exceptions and inconsistencies and, and they can also be derived
from a complete and internally consistent set of high-level principles. An example for this
are German GoB: German GoB comprise principles as well as more specific guidance,
which courts consistently derive from the high-level principles; in this sense, even the more
concrete guidance is ‘principles-based’ (Beisse, 1990). On the other hand, principles as de-
fined in the accounting literature do not necessarily have to be internally consistent
(Walker, 2007, p. 53).

We hold that many of the problems related to rules under U. S. GAAP and IFRS, such
as scope exceptions and excessive implementation guidance, do not require the elimination
of all specific guidance as requested by some in the accounting literature. We argue that
they may also be resolved by eliminating the inconsistencies within the respective account-
ing regimes. For example, if IAS 39 would require measurement of all financial instruments
 – 18 –

by reference to a consistent measurement basis the standard would (automatically) contain

much less specific guidance.

Impact of the Level of Detail of Accounting Standards on Consistency in their Application

As shown above principles-based standards may, even if they are internally consistent,
be applied differently to identical issues by different companies and thus do not ensure
consistency in the application of the accounting standards. That is because principles alone
do not provide a sufficient structure to limit management’s judgment in the application of
the principles to specific transactions and events. This means that if consistency as regards
the application of accounting standards is strived for rules, which are consistently devel-
oped on the basis of the high-level principles, needs to be provided.

The following example shall illustrate the argument: A revenue recognition principle
could be that revenue should be recognized when the inflow of economic benefits is prob-
able. Since it depends on management’s judgment when the inflow of economic benefits is
regarded as probable, it may happen that in the case of an identical sales contract one com-
pany recognizes revenue at contract conclusion while another company recognizes revenue
with the receipt of cash. If consistency in the application of accounting standards shall be
ensured consistent rules for different types of revenue-generating transactions need to be
provided. A rule for the sale of goods could be that revenue shall be recognized when the
good is handed over to the customer and not significant additional obligations remain to be
fulfilled (more specific (consistent) guidance for additional obligations, such as warranties,
may be provided). Since the risk that the sold product does not conform to the contractu-
ally agreed specifications is higher in construction contracts than in sales contracts a consis-
tent revenue recognition rule would require the customer’s acceptance of the finished
product for revenue to be recognized.

5. Discussion

In the following discussion we loosen our previous assumption that a consistent appli-
cation of accounting standards by all companies is requested and critically discuss and bal-
ance the advantages and disadvantages of principles-based and rules-based accounting
standards. We come to the conclusion that for reasons of comparability, enforceability and
objectivity of financial reporting information it is important to have specific (internally
consistent) accounting requirements that limit management‘s judgment in the application
of accounting standards to ideally only one possible accounting treatment. We acknowledge,
 – 19 –

however, that this may, in some situations, lead to an impaired relevance of financial re-
porting information.

Rules-based Standards Increase the Comparability of Financial Reporting Information

Raz (1972) and others consider rules to lead ‘more easily to uniform and predictable
application’ and thus to create consistency and comparability (p. 841; McBarnet and Whe-
lan, 1991, p. 848-849 and ICAS, 2006b, p. 10-11). By contrast, principles, according to
Dickey and Scanlon (2006), may be applied differently to identical cases across companies
due to differences in the use of judgment thereby leading to a lack of comparability and
consistency in the application of accounting standards (p. 13; see also Coglianese et al.,
2004, p. 38; Kivi, Smith and Wagner, 2004, p. 12; SEC, 2003, I.C.).

Doubtlessly, comparability is a desirable characteristic of financial reporting: Especially

in the U. S. accounting literature many authors, such as Schipper (2003), emphasize the
need for comparability of financial statements (p. 62-63; see also Wolk, Tearney and Dodd,
2001, p. 289-90). It is demanded and much valued by investors (Choi and McCarthy, 2003,
p. 7 referring to a letter issued by the Association for Investment Management and Re-
search in 2000), it is one of the very reasons for the existence of accounting standards
(Previts and Merino, 1998, p. 228-34; Schipper, 2003, p. 62) and even for the EU to require
listed companies to apply uniform accounting standards in the form of IFRS in their con-
solidated accounts (Article 1 IAS Regulation).

However, cross-firm comparability of financial statements, implying that a company

showing high income at the end of the accounting period is economically better off than
other companies with a lower income number, is not achievable, not even by means of
uniform accounting standards (Bonham et al., 2008, p. 75). One reason brought forward by
Alexander and Jermakowicz (2006) is that the application of specific rules may require eco-
nomically different situations to be accounted for identically and thus create a pseudo-
comparability (Alexander and Jermakowicz, 2006, p. 150; see also Benston, Bromwich and
Wagenhofer, 2006, p. 169-70; Dye and Sunder, 2001, p. 266). The following example may
illustrate the point: Consider a rule prescribing that liabilities shall only be recognized if the
probability of the outflow of resources is higher than 50 percent (see IAS 37.23 for a simi-
lar rule). In the case of a pending law suit, a company, which expects to be ordered to pay
damages with a five percent probability and another company expecting to have to pay
damages with a 45 percent probability both, according to this rule, do not anticipate the
potential outflow of resources in the form of a liability. Hence, both companies show the
same amount of income in the accounts even though their economic situation is different.
 – 20 –

Principles-based Accounting Standards Increase the Relevance of Financial Reporting Information

Apart from the creation of a ‘pseudo-comparability’ in some cases rules are criticized
for failing to capture the particularities of individual cases (Bratton, 2003, p. 1037) and for
allowing preparers to ‘structure transactions ‘”around” the prescriptions, thereby circum-
venting the intent and spirit of the standards’ (FASB, 2002, p. 2; Kivi, Smith and Wagner,
2004, p. 12; Cunningham, 2007, p. 11; McBarnet and Whelan, 1991, p. 849). Principles, by
contrast, are regarded as being hardly susceptible to an evasion of their intended purpose
(Broshko and Li, 2006, p. 5) and, due to their flexibility and the required use of profes-
sional judgment, as having the capacity to give consideration to the particularities of indi-
vidual cases (Bratton, 2003, p. 1037; Cunningham, 2007, p. 11). Referring to the example
above, a principle could be to recognize all present obligations as liabilities even if the
probability of the resource outflow is less likely than 50 percent, and to measure them at
fair value (see for a similar approach ED-IAS 37).

Another reason why many, e.g. Alexander and Jermakowicz (2006), argue that princi-
ples provide more relevant information than rules is that management best knows the eco-
nomic reality and how to account for it (p. 150; see also AAA FASC, 2003, p. 74 and 76;
ICAS, 2006b, p. 69). Others, e. g. Bagnoli/Watts (2005), furthermore highlight the positive
influence of the existence of implicit accounting choices on the relevance of financial re-
porting information by providing evidence that management’s accounting policy choices
allow the market to infer management’s private information about the firm’s economic
situation (‘signaling effect’) (p. 798; see e.g. Wyatt (2005) for the signaling effect with regard
to the recognition of intangible assets).

However, the downside of the flexibility of principles is, according to Beechy (2005),
that management may not always choose the most relevant accounting treatment since
managers are always biased − even if they do not have fraudulent intentions ( p. 199; see
also Nelson, 2003, p. 100). Guenther (2005) attributes this, amongst other things, to the
pressure to present good results, especially, when the personal income is bound to the
achieved results (p. 6 and p. 12-13). Rentfro and Hooks (2004) additionally remark that the
recent corporate scandals, such as the case of Enron, indicate anecdotally that management
does not always apply accounting norms in good faith (p. 89). Principles-based accounting
standards are hence criticized for providing increased potential for earnings management
(Benston, Bromwich and Wagenhofer, 2006, p. 173; Beechy, 2005, p. 199−200; see also
Watts and Zimmerman, 1986, p. 206 and Kivi, Smith and Wagner, 2004, p. 12).
 – 21 –

In conformity with this, Ewert and Wagenhofer (2005) find that tighter accounting
standards reduce earnings management. However, they also find evidence that tighter ac-
counting standards increase real earnings management, i.e. the change of the structure of
transactions or events in order to avoid the consequences specified by an accounting stan-
dard (Ewert and Wagenhofer, 2005).

Rules-based Standards Increase the Enforceability of Financial Reporting Standards

Since in the case of rules actors know without ambiguity what to do in order to obey
with the rules the advantage of rules is seen in their contribution to certainty and enforce-
ability (ICAS, 2006b, p. 10-11; see also Braithwaite, 2002, p. 4; Cunningham, 2007, p. 11;
Mc Barnet and Whelan, 1991, p. 848-49 and 857; Raz, 1972, p. 841). On the other hand
principles, due to their vagueness, are regarded to be difficult to enforce and thus to create
uncertainty (Cunningham, 2007, p. 11).

As stated above, in the case of principles-based standards enforcing agencies have to

accept that companies account for identical transactions differently. Consequently, the
agencies shall only be allowed to second-guess management’s professional judgement if the
selected accounting policies are not in conformity with the high-level principles or if the
judgement was not made ‘in good faith’. But, since principles-based standards allow differ-
ing interpretations of the broad principles it will − especially in the absence of specific
guidance − often be difficult to judge whether an adopted accounting policy conforms to
the principles and whether the judgement was made in good faith (Kivi, Smith and Wagner,
2004, p. 12). Some therefore doubt that regulators in litigious environments, such as the
U. S., will be willing to accept different applications of the same principles (Taub, 2004).
Dickey and Scanlon (2006) point out that in this case, preparers would be exposed to a
higher risk of litigation because enforcing agencies may allege violation even if the required
professional judgement was exerted in good faith (p. 16; see also SEC, 2003, I.C. with fur-
ther references).

The fact that IFRS have not yet been frequently subject to litigation may be attributed
to the fact that the application of IFRS had only been mandatory in very few countries
until recently. However, with the adoption of IFRS in the EU the Standards and Interpre-
tations have become parts of the European legal framework (see for details Wüstemann
and Kierzek, 2007). Thus, it is likely that IFRS will increasingly become subject to litigation.
Since one of the objectives of the IAS Regulation is to standardize European financial re-
porting, at least in the consolidated accounts of listed EU companies (Article 1 IAS Regula-
tion), it is highly questionable whether the European Court of Justice will accept different
 – 22 –

interpretations of the IFRS principles (Schön, 2004, p. 767; Wüstemann and Kierzek, 2006,
p. 94 et seq. and pp. 105−107).

Rules-based Standards Increase the Objectivity of Financial Reporting Information

In the accounting literature the quest for consistency as regards the application of ac-
counting principles is mostly reasoned with the requirement for comparability of financial
statements (see e.g. Schipper (2003), p. 62). Some believe that there is another reason,
which is of equal importance: Apart from providing decision-useful information, account-
ing is also frequently used in contracts, for instance in employment contracts and debt
covenants, in order to calculate annual bonuses or to limit future debt levels (Watts and
Zimmerman, 1986, p. 196). Guenther, for instance, points out that such accounting-based
contracts only efficiently balance the interests of the contracting parties if there is agree-
ment on how the relevant accounting numbers are calculated (p. 5-8). As stated above,
principles-based accounting standards sometimes permit management to choose between
several different accounting treatments. With regard to debt covenants principles-based
standards thus enable managers to circumvent covenant restrictions by (voluntarily) chang-
ing to a more favorable accounting method (Healy and Palepu, 1990, p. 97, referring to
accounting choices under U. S. GAAP). Indeed, many researches, e.g. Smith and Warner
(1979), have provided sound empirical evidence that managers make use of this flexibility
in order to avoid costly violations of the contract (see also Beatty and Weber, 2003; El-
Gazzar, Lilien and Pastena, 1989; Sweeney, 1994).

Watts and Zimmerman (1990) argue that flexibility in the choice of accounting policies
increases costs and thus decreases contract efficiency (p. 135). That is because lenders ei-
ther price-protect themselves against management’s ‘creative accounting’ or they restrict
the number of available accounting treatments by using fixed GAAP provisions, which are
costly to negotiate and monitor for the lender and costly for the borrower because he
needs to prepare an extra set of financial statements for contracting purposes (Watts and
Zimmerman, 1986; p. 213 et seqq.; Mohrmann, 1996, p. 81). According to Leftwich (1983)
another downside of vague principles from a contracting perspective of financial reporting
is that they create uncertainty about the terms of the contract and increase the risk of litiga-
tion between the contracting parties (p. 28-29).

By reference to the measurement attributes under U. S. GAAP Leftwich (1983) further

points out that costs could be reduced if less accounting options were available (p. 25). In
conformity with this, Watts and Zimmerman (1986) argue that the effectiveness of cove-
nants requires a restriction of accounting choices (p. 220).
 – 23 –

It follows that from a contracting perspective of financial reporting, it is essential to

restrict management’s judgment in the absence of clear guidance to ideally only one possi-
ble accounting treatment. Principles-based accounting standards apparently fail to ensure
this since they often allow management to choose between different accounting treatments.
The advantage of rules-based accounting standards (not necessarily containing bright-line
tests that allow management to circumvent the rules’ purpose) is that they provide clear
guidance and, through this, limit management’s ability to influence the relevant accounting
numbers. Anyhow, if the rules are not internally consistent, management may, in the ab-
sence of concrete guidance, arbitrarily choose between several even opposing accounting
policies. From a contracting perspective, specific accounting norms are therefore only ef-
fective if they are internally consistent.

It becomes obvious that when discussing whether rules or principles are favorable a
trade-off between relevance on the one hand and comparability, enforceability and objec-
tivity needs to be made. The AAA FASC (p. 74) makes the point clear by providing an
example similar to the following one: A rule prescribing that certain assets shall be depreci-
ated over ten years would most probably be applied consistently by all companies, it would
create comparability and it would be easily enforceable. However, the rule does not neces-
sarily provide useful information because it fails to reflect the ‘real’ decline in the asset’s
economic value. A principle stating that all assets shall be depreciated according to the de-
cline of their economic value in the respective accounting period may provide more rele-
vant information, but it is rather unlikely that all companies would make identical estimates
with regard to the ‘real’ economic value of a certain asset, i.e. the principle would not be
applied consistently to identical events by all companies. Furthermore, the estimation of an
asset’s fair value opens potential for earnings management and it is difficult to judge
whether it was made in good faith and thus should not be second-guessed.

6. Conclusion and Suggestions

We argued that for reasons of comparability, enforceability and objectivity it is particu-

larly important to limit management’s judgment in the application of accounting standards
to ideally one possible accounting treatment. According to our analysis, the present IFRS
regime does, for a large part, not ensure this. That is because the inconsistencies between
the objectives, qualitative characteristics and general recognition and measurement criteria
in the IASB Framework as well as between the requirements and guidance in certain Stan-
dards and Interpretations permit managers to (sometimes arbitrarily) choose between dif-
 – 24 –

ferent accounting policies in the absence of clear guidance. This result led us to the conclu-
sion that consistency in the application of accounting standards requires at least consis-
tency between the accounting standards themselves.

When exploring the differences of principles-based and rules-based accounting stan-

dards we found that internal consistency alone cannot sufficiently ensure a coherent appli-
cation of accounting standards. That is because principles do not provide a sufficient struc-
ture to limit management’s judgment in the application of the principles to specific transac-
tions and events.

We argue that accounting regimes should be principles-based, but should not consist
of principles only. This means that there should be a set of high-level principles from
which more concrete accounting rules are consistently derived. Due to the consistency
between rules addressing comparable issues management’s flexibility in the application of
accounting standards would be much more limited than under present U.S. GAAP and
IFRS.

It may be important to note that we developed our arguments for internal consistency
in a normative way. We agree with Alexander’s and Jermakowicz’s (2006) objection that the
‘absolute’ consistency of all accounting principles is not achievable (p. 150). However, just
as in the case of other ideals, such as justice, equality and freedom, the impossibility to
achieve internal consistency in absolute terms does, from a normative perspective, not im-
ply that it is not desirable and should not be aimed at.
 – 25 –

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