How Does the Strength of the Financial Regulatory Regime Influence Auditors' Judgments to Constrain Aggressive Reporting in a Principles-Based Versus Rules-Based Accounting Environment?

Abstract

SYNOPSIS: With the movement toward adoption of International Financial Reporting Standards (IFRS) worldwide, a question arises as to whether the adoption of a principles-based approach, such as IFRS, will ultimately result in higher-quality financial reporting. This issue is particularly relevant because, even though for now the SEC is not adopting IFRS, the securities markets and the SEC still need to ponder the implications of a decision that may lead to the ultimate adoption of, or at least some degree of convergence with, IFRS in the U.S. To examine this issue, we employ an experiment with 97 experienced auditors as participants. Using a case setting involving the classification of a lease (operating versus capital), we manipulate the accounting standard type as rules-based or principles-based, and the regulatory regime as stronger or weaker. The lease setting is one where there are indications of management's incentives to leave the debt off of the balance sheet and, hence, engage in aggressive reporting. We find, as expected, that auditors are more likely to constrain aggressive reporting under principles-based accounting standards than under rules-based standards, under both stronger and weaker regulatory regimes. Importantly, from a public policy perspective, the results indicate that auditors' judgments under principles-based standards, regardless of the strength of the financial regulatory regime, lead to more conservative reporting when compared to rules-based standards coupled with a stronger financial regulatory regime, which is the way the U.S. environment is often characterized.

Auditors' Response to Different Reporting Environments: Experimental Evidence From the Quantity and Quality of Auditors' Evidence Demands in China

“…Recent studies on this topic have found that under principlesbased accounting standards, auditors are more likely to constrain aggressive reporting (Cohen, Krishnamoorthy, Peytcheva, & Wright, 2013) and increase process accountability, epistemic motivation, and demand for evidence (Peytcheva, Wright, & Majoor, 2014). Our study adds to prior research by investigating how auditors play their role in the implementation of principles-based versus rules-based accounting standards in China, which is an environment where auditors have experienced recent changes to accounting standards.…”

“…The influence of the type of accounting standards on auditing varies from country to country since the strength of the financial regulatory regime is significantly different across countries (Ball, 2006). Part of the mechanism behind this may be that auditors' efforts, accountabilities, and focus may vary under principlesbased versus rules-based accounting standards based on the strength of the financial regulatory regime (Cohen et al, 2013). Part of the mechanism behind this may be that auditors' efforts, accountabilities, and focus may vary under principlesbased versus rules-based accounting standards based on the strength of the financial regulatory regime (Cohen et al, 2013).…”

“…This was not done in Cohen et al (2013), although Peytcheva et al (2014) included a subset of Dutch auditors who would have been experienced with IFRS. This was not done in Cohen et al (2013), although Peytcheva et al (2014) included a subset of Dutch auditors who would have been experienced with IFRS.…”

The standard-setters’ toolkit: can principles prevail over bright lines?

“…16 This could occur, for example, if international auditors standardize practice advice across jurisdictions or if auditors believe that the bright-line criteria fairly reflect the principle. Cohen et al (2013) find, in an experimental setting with bright-line tests, that auditors are more likely to require capitalization when the standard contains a professional judgement clause. Nelson et al (2002) report that auditors believe that firms use transaction structuring less under principles-based standards but also note that less precise standards can create room for auditor-client negotiation to achieve client reporting goals.…”

Auditor Tolerance of Accrual-Based and Real Earnings Management in Boardrooms of Politically Connected Nigerian Firms

“…In particular, auditors are typically alleged of having conspired with managers to manipulate financial reports because the audited financial statement of an audit client represents the outcome of an audit process determined through "auditor-client negotiation" (Gibbins, Salterio & Webb 2001). Therefore, since one of the primary duties of an auditor is to curtail the aggressive reporting of managers (Cohen et al 2013), the audited financial statement captures the level of reporting discretion and the earnings quality that an auditor's judgement permits his or her client (Antle & Nalebuff 1991). Accrual quality is a metric that is frequently used by researchers to capture the extent of an auditor's tolerance of a client's opportunistic reporting behaviour (DeFond & Zhang 2014;Jamal & Tan 2010).…”