Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions

Abstract

Recent accounting scandals have resulted in regulatory initiatives designed to strengthen audit committee oversight of corporate financial reporting and have led to a concern that U.S. GAAP has become too rules-based. We examine issues related to these initiatives using two experiments. CFOs in our experiments exhibit more agreement and are less likely to report aggressively under a less precise (more principles-based) standard than under a more precise (more rules-based) standard. Our results also indicate that CFOs applying a more precise standard are less likely to report aggressively in the presence of a strong audit committee than a weak audit committee. We find no effect of audit committee strength when the standard is less precise. Finally, we find support for a three-path mediating model examining mechanisms driving the effect of standard precision on aggressive reporting decisions. These results should be of interest to U.S. policymakers as they continue to contemplate a shift to more principles-based accounting standards (e.g., IFRS).

Manager's Discretionary Power and Comparability of Financial Reports: An Analysis of the Regulatory Transition Process in Brazilian Accounting

“…In the model adjusted by stepwise, the years 2011 and 2012 had a significantly higher average comparability when compared to 2004. The results found corroborate other researches addressing the quality of accounting information (Collins, Pasewark, & Riley, 2012;Psaros & Trotman, 2004;Agoglia, Doupnik, & Tsakumis, 2011) and prove the superiority of the principle-based standard also over the comparability of financial reports. The main conclusion of this research is that increasing manager's discretionary power through flexibility of accounting standards does not decrease the comparability of financial reports.…”

“…According to the authors, their findings contradict the arguments that inaccurate standards taking into account the substance under the form makes them less effective to fight biases in financial reports when compared to rule-based standards. Corroborating the findings of Psaros and Trotman (2004), Agoglia et al (2011) observed in their experiments that financial directors subject to a more flexible regulatory system are less exposed to aggressive practices in financial reporting than financial directors in stricter systems. Overall, based on these studies, we notice the existence of a proven superiority of the standard based on principles over the standard based on rules.…”

“…Those who support principles claim they improve quality in the information environment and not necessarily increase variability in the accounting outcomes (Silva, 2013;Agoglia, Doupnik, & Tsakumis, 2011;Donelson, McInnis, & Mergenthaler, 2012;Jamal & Tan, 2010;Mergenthaler, 2009;Stolowy & Ding, 2003;Psaros & Trotman, 2004;Iatridis, 2010). Those supporting rules point out the contrary: that without the latter, there is no comparability and managers might be susceptible to greater manipulation of outcomes (Sunder, 2009;Schipper, 2003;D' Arcy, 2000).…”

“…Although there are empirical studies that evaluated the effects of regulatory changes on outcomes of financial reports or on the interpretive behavior of a manager in translating economic events into accounting numbers (Agoglia et al, 2011;Collins et al, 2012;Dye, 1985;Dye & Verrecchia, 1995;Psaros & Trotman, 2004;Stolowy & Ding, 2003;Ashbaugh, 2001;Ashbaugh & Pincus, 2001;Nelson, 2003;Jamal & Tan, 2010;Donelson et al, 2012), there is little prior evidence of the impact of regulatory flexibility directly on the comparability of financial reThe corporate scandals that occurred in the beginning of the last decade (e.g. Enron and WorldCom) and the subprime crisis in the USA rekindled an old debate between accountants on how accounting should be regulated: according to rather strict and specific rules or rather flexible and generic principles -for more details see Merino and Coe (1978).…”

“…an increased level of judgment allows managers to incorporate more properly the economic events and their various nuances in accounting numbers, thus increasing their comparability (Dye & Verrecchia, 1995;Securities and Exchange Commission, 2003;Agoglia et al, 2011). The studies by Collins et al (2012) and Agoglia et al (2011) found differences between accounting choices (and, as a consequence, in the final outcome of financial reports) by managers working under rather strict regulatory systems when compared to those working under rather flexible systems, although in the latter no rather scattered outcomes have been found. In turn, Dye and Verrecchia (1995) argue, based on their research, that a pattern with greater discretion is more informative than a strict pattern.…”