Rules-Based Versus Principles-Based Accounting Standards

1. Rules-Based Versus Principles-Based Accounting Standards Rick Mergenthaler University of Iowa

2. 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.

3. 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.

4. 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.

5. 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

6. RBC Measure How do I calculate RBC? • Identify characteristics of rules-based standards • Determine if the characteristics are contained in the standard • Add one point to the RBC measure for each characteristic the standard contains

7. 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

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. Textual Analysis A Key-word dictionary was created using the following steps. • Two co-authors independently read and reviewed each standard to identify potential key-words for each standard. • These coauthors then discussed the potential key-word search terms for each standard and created a preliminary key-word search term dictionary. • The key-word search term dictionary was sent the national office of one of the Big 4 firms. • 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.

14. Textual Analysis (cont.) A Keyword List was created using the following steps. • 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. • 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.

15. 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”

16. 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.

17. 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.

18. 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.

19. 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.

20. Questions?

21. Thank You!