Question

Present your perspective on the disadvantages and advantages of rules-based and principle based accounting standards, in relation to the expensing of goodwill

Answer 1

Accounting standards are guidelines for accounting of various transactions in books of Accounts. Compliance with standards is mandatory. Accounting standards were introduced with the objective of maintaining comparability of financial information across the entities. The entities in the same industry would follows different set of principles to record financial information, otherwise. However, accounting standards cannot specify one type of treatment as economic and operating environments of different industries would vary from each other. Hence, standards can curtail the number of alternatives, but cannot specify single alternative.

There are two types of accounting standards – Rule-based and Principle-based. Rule-based standards would specify the situation and accounting treatment that should be followed. These standards specify the conditions to be satisfied and accounting treatment if different sets of conditions are satisfied. Principle-based standards specify the accounting treatment based on principles, without any standard set of conditions to be met. These standards do not give any checks. They specify the accounting treatment in a broad way. The management of the entity should decide about the application of standard. This leaves a room for lot of estimates and assumptions.

According to the standards, goodwill should be recognized in books of Accounts when acquired with consideration. Self-generated goodwill cannot be recognized. After recognition, goodwill should be expensed over the estimated useful life. This process is called amortization.

Principle-based standards specify that goodwill should be expensed over its useful life. Advantages here are that the management, with its experience and considering the external and internal environments of the business, can determine the useful life. Useful life cannot be standardized due to its differentiating nature to different industries. However, disadvantage would be that this non-standardization makes the management estimate the useful life. Estimations are never certain or accurate. They are approximations. Management may manipulate earnings using these assumptions.

Rule-based standards give a certain set of conditions and goodwill expense method to be followed under each set. The advantage of these standards would be the unambiguity regarding method to be used. However, disadvantage would be the same set of conditions might not be applicable to all industries. Also, sometimes conditions across different sets might be met, which leaves the management unable to decide the set of conditions to be considered.