Rules-Based Versus Principles-Based Accounting Standards

Rick MergenthalerUniversity of Iowa

Motivation

Accounting Scandals (e.g., Enron)

Congress asks the SEC to examine implications of adopting more principles-based standards in the U.S.

The SEC releases a Roadmap to IFRS adoption, which is believed to be more “principles-based” than U.S. GAAP.

Motivation (cont.)

There is little evidence on the implications of such a shift.

Prior studies (SEC 2003, Schipper 2003, Nelson 2003) discuss the arguments of both critics and proponents.

• Proponents argue that principles-based standards allow management to better communicate the firms current and expected future performance.

• Critics allege that principles-based standards will decrease comparability, verifiability, increase preparer costs, and increase the likelihood of litigation.

Identifying Rules-Based Standards

There is no agreed upon definition of rules-based or principles-based standards.

The following studies describe characteristics of rules-based standards.

Schipper (2003) SEC (2003) Nelson (2003)

I approach the issue from an empirical perspective and attempt to measure the extent to which a standard contains rules-based characteristics.

Identifying Rules-Based Standards (cont.)

I use several sources to identify the characteristics of rules-based standards, including (1) the SEC, (2) the FASB, and (3) Prior literature (e.g. Schipper 2003, Nelson 2003, Bartov et al. 2003).

Characteristics of rules-based standards

Bright-line thresholds

Scope and legacy exceptions

Large volumes of implementation guidance

High level of detail

RBC Measure

How do I calculate RBC?

1. Identify characteristics of rules-based standards

2. Determine if the characteristics are contained in the standard

3. Add one point to the RBC measure for each characteristic the standard contains

Examples of the RBC Calculation

FAS 13• Fourteen exceptions• Four bright-line thresholds• Forty one interpretive releases• 72,270 words

FAS 5• Zero exceptions• Zero bright-line thresholds• Three interpretive releases• 15,738 words

+1+1+1+1 4

+0+0+0+0 0

RBC Validation

RBC scores are broadly consistent with the SEC’s classification of certain standards as principles-based or rules-based.

RBC measures IFRS standards as more principles-based than U.S. GAAP.

Untabulated factor analyses reveal that there is one underlying factor.

RBC Pros and Cons

Pros

• The measure is objective and can be computed for all standards.

• It is easy to track how U.S. GAAP or any standard has changed over time by recalculating RBC each time a standard changes.

• The measure lines up with experts view of “rules-based” standards.

Cons

• The measure can only be used in instances where a violation is identified (i.e., fraud, litigation, changes in standards).

• The measure isn’t motivated by theory.

Why Are Standards Rules-Based?

Donelson, McInnis, and Mergenthaler (2013)

Standards tend to be rules-based when the underlying transactions are complex.

Standards tend to be more rules-based when transactions frequently occur.

Standards tend to be more rules-based in areas of GAAP where litigation and enforcement occur.

Rules-Based Accounting Standards and Litigation

Donelson, McInnis, and Mergenthaler (2012)

In cases where no restatement occurs, plaintiffs tend not to target rules-based areas of GAAP—likely because they lack objective evidence to show that a detailed rule was violated.

In cases where a restatement occurs, firms violating a rules-based standards are less likely to be sued—likely because rules-based areas of GAAP are so complex it is difficult to show that the manager acted with the intent to defraud.

These findings are consistent with rules-based standards protecting firms from litigation.

PSCORE

Objective: Create a measure that captures the firm’s reliance on principles-based standards.

Method: Textual analysis combined with RBC.

Higher values of PSCORE are consistent with greater reliance on principle-based standards in a given firm-year.

Textual Analysis

A Key-word dictionary was created using the following steps.

1. Two co-authors independently read and reviewed each standard to identify potential key-words for each standard.

2. These coauthors then discussed the potential key-word search terms for each standard and created a preliminary key-word search term dictionary.

3. The key-word search term dictionary was sent the national office of one of the Big 4 firms.

4. The list of key-words for each standard was reviewed by a technical expert that advises local offices of that Big 4 firm on the application of GAAP for that particular standard.

Textual Analysis (cont.)

A Keyword List was created using the following steps.

5. The technical experts at the Big 4 firm modified the key-word search terms as necessary and added key-words when a key-word was missing from the initial key-word dictionary.

6. Two co-authors then independently reviewed the key-word dictionary and searched a random sample of 10-Ks to ensure that the key-word dictionary appropriately identified that a firm was impacted by the standard when the standard’s key-words were mentioned in a firm’s 10-K.

Keyword Examples

SFAS 34 – Capitalization of Interest Cost• “interest” w/3 “capitaliz*”• Common terms for standard name

SFAS 146 – Restructurings• “restruct*” “exp*”• “exit” OR “disposal” “activit*”• “restruct*” “charge”• “one-time termination benefit”• “exit” w/5 “disposal activit*” w/10 “termination benefit”

Measuring PSCORE

We count how many times the keywords are mentioned in each firm’s 10-K.

We standardize the keyword counts:

This helps alleviate concerns that keywords are not uniform in specificity across standards.

We also “add back” the minimum score for each standard year so that zero “hits” has a count of zero.

𝑅𝐸𝐿_𝐼𝑀𝑃𝑖𝑡𝑠 = ሺ𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡𝑖𝑡𝑠 − 𝑎𝑣𝑔_𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡𝑡𝑠ሻstd_dev (𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡𝑡𝑠)

Measuring PSCORE

Multiply standard count score by RBC1 and sum across all standards for the firm.

Multiply by negative one to make measure increasing in principles-based standards.

𝑃𝑆𝐶𝑂𝑅𝐸𝑖𝑡 = −1∗𝛴𝑠=1𝑆 ൫𝑅𝐸𝐿𝐼𝑀𝑃𝑖𝑡𝑠 × 𝑅𝐵𝐶1𝑡𝑠൯

PSCORE Validation

We examine the keyword count for industry-specific standards.

• We find that our keyword search terms are frequently mentioned by companies conducting business in the industry to which the standard applies.

We correlate the number of keyword hits with the dollar magnitude of the corresponding financial statement line items.

• We find a strong positive correlation between the number of key-word hits and the dollar magnitude of the corresponding financial statement line item.

Principles-Based Standards and Earnings Attributes

Folsom, Hribar, Mergenthaler, and Peterson (2013)

Firms that rely more by principles-based standards have:

More informative earnings

More persistent earnings

A higher association between earnings and future cash flows.

These findings are consistent with managers using the discretion provided by principles-based standards to communicate the economic substance of transactions to investors.

Questions?

Thank You!