Behavioral Evidence on the Effects of

Principles- and Rules-Based Standards

Mark W. Nelson
Professor of Accounting
Johnson Graduate School of Management
Cornell University
448 Sage Hall
Ithaca, NY 14853-6201
Email: [email protected]

November 22, 2002

Forthcoming: Accounting Horizons

I appreciate comments from Rob Bloomfield, Dennis Caplan, Robert Freeman, Bob Libby, Bob
Lipe, Paul Munter, Bob Swieringa, and Hun-Tong Tan. I am grateful for financial support
provided by Cornell’s Johnson Graduate School of Management.

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 Behavioral Evidence on the Effects of
Principles- and Rules-Based Standards
INTRODUCTION

The Sarbanes-Oxley Act requires the SEC to study the feasibility of shifting to a more

“principles-based” financial-reporting system (Sarbanes-Oxley Act of 2002), and the FASB has

proposed changes designed to create a more principles-based approach to standard setting (FASB

2002). This commentary reviews research relevant to predicting how the behavior of various

participants in the financial-reporting process is affected by principles-based and rules-based

standards.

Because U.S. accounting standards typically are written to operationalize the FASB’s

underlying conceptual framework, they are based on principles. The standards also provide

guidance as to correct accounting or disclosure treatment, so they include rules. As a

consequence, an immediate challenge in writing this review is to define exactly what it means for

a standard to be “principles-based” or “rules-based.” I restate the “principles-based vs. rules-

based standards” question in a way that is more conducive to extracting insights from the

existing research literature. Assuming that the FASB continues to base standards on the

framework of principles articulated in the FASB’s concepts statements, all standards can be

viewed as principles based, and the issue is the incremental effect on behavior when standards

include relatively more elaborate rules. Therefore, in this commentary I discuss standards in

terms of being more or less rules-based, acknowledging that less rules-based standards must rely

more on principles to guide behavior. I define “rules” broadly to include specific criteria,

“bright-line” thresholds, examples, scope restrictions, exceptions, subsequent precedents,

implementation guidance, etc. A “standard” is the total body of principles and rules that apply to

a given accounting issue.

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The “Incremental” Perspective

This incremental perspective is useful in at least two ways. First, it focuses the review on

the incremental effects of increasing the number of rules in a standard. I argue that adding rules

affects the precision and complexity of an accounting standard, and consider the implications of

studies that examine the effects of precision and complexity on the behavior of participants in the

financial reporting process.

Second, the incremental perspective may provide insight about the effect of varying the

extent to which different standards appear to be principles-based or rules-based. Some

accounting topics involve complex transactions with predictable characteristics, so it is possible

to write standards that contain very specific thresholds. For example, leases typically involve

physical assets and a contractually defined sequence of cash flows, and SFAS No. 13 uses

numerical thresholds to specify criteria regarding the proportion of lease life and the amount of

fair value. These sorts of accounting topics are amenable to rules, but don’t necessarily require

them, so standard-setters must choose the extent to which the standard is to be rules based.

Other accounting topics have less predictable characteristics and more inherent judgment. For

example, SFAS No. 5 involves estimates of probability and amounts that are not defined

contractually. Because these topics are less amenable to rules or bright-line thresholds, the

standards that govern them are more principles-based by default. Finally, including precedents

and implementation guidance in the definition of rules highlights that the extent to which a

standard appears rules-based changes over time, as a particular standard accretes implementation

guidance, interpretations and technical rulings. One reason why relatively younger standard-

setting regimes like the IAS appear more principles-based is that they haven’t had as much time

to accrete rules.

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 I review the incremental effects of rule precision and complexity on performance with

respect to two important functions of financial-accounting standards: communication and

constraint. Communication refers to the role standards play in conveying GAAP to

practitioners and facilitating a shared understanding of the meaning of financial reports.

Assuming incentives to report accurately, how does the extent to which standards are rule-based

influence their ability to communicate? Constraint refers to the role of standards in

discouraging biased communication by serving as the benchmark for assessing and defending the

accuracy of communications. Assuming incentives to report inaccurately, how does the extent to

which standards are rule-based constrain biased communication? Following separate discussions

of research on communication and constraint, I discuss the tradeoffs between them.

Focus on Experimental and Survey Research

I review research from financial accounting, auditing, and tax, recognizing that although

these areas differ in important ways, basic behavioral responses generalize across areas. I focus

on evidence provided by experimental and survey studies. To my knowledge, few archival

studies examine whether decision makers alter their behavior depending on the precision and

complexity of relevant accounting standards.1 Also, because this review focuses on observed

behavior, I exclude analytical studies in law and accounting that predict and/or model how

behavior varies with rule precision and/or complexity.2

The relative strengths and weaknesses of research approaches influence their ability to

address issues relevant to accounting policy. Good experiments abstract from practice and

randomly assign participants to alternative treatments (Kachelmeier and King 2002; Libby et al

2002). This approach provides much control and enables strong causal inferences from

directional changes in observed behavior, but also requires care when generalizing to practice.

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Good surveys elicit detailed information from a broad range of sophisticated practitioners

(Gibbins 2001). This approach provides rich insight into the practice setting but involves self-

reported data of uncertain validity and generality. Given these methodological strengths and

weaknesses, I present research findings in terms of general behavioral responses to particular

characteristics, such as, “when the precision of a standard increases, people will tend to do X

more frequently,” rather than attempting to predict the exact levels of behavior that occur under a

particular type of standard.

COMMUNICATING GAAP

I consider two ways in which standards can increase their communication accuracy: (1)

standards can include precise, “bright-line” thresholds, and (2) standards can use a larger number

of rules.

Quantitative and Qualitative Thresholds

Standards often use “bright-line” criteria to distinguish between broad classes of

transactions that have different accounting treatments.3 For example, SFAS No. 13 requires

capital-lease treatment when the lease term is equal to 75 percent or more of the estimated

economic life of the property. As an alternative, SFAS No. 13 could have required capital-lease

treatment if the lease term constituted most of the estimated economic life of the property, but

the meaning of “most” is less clear than the meaning of “75 percent.” Given that practitioners

can calculate the amounts that are compared to the precise threshold, bright-line descriptions of

quantity communicate accurately, and appear throughout the financial accounting standards, as

illustrated by Table 1 of FASB Concepts Statement No. 2.

Less precise expressions are often used to communicate other types of thresholds. For

example, SFAS No. 5 requires accruing a loss contingency when the loss can be reasonably

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estimated and it is probable that a liability has been incurred or an asset impaired. One concern

about the use of such imprecise expressions is that practitioners will interpret them differently,

leading to low consensus among practitioners and potential lack of comparability between

financial reports. Several studies that elicit numerical interpretations of the SFAS No. 5

probability expressions from experienced auditors support this concern. For example, Amer et

al. (1994) find relatively high variance in audit managers’ interpretations of probability

expressions, suggesting that these expressions sometimes are interpreted differently than

standard-setters intended when applied in a given context. Amer et al. (1995) also provide

evidence that audit managers’ interpretations of “probable” vary predictably between contexts in

which SFAS No. 5 is applied, in a manner that was not intended by the FASB members who

promulgated SFAS No. 5.

High variance in probability-threshold interpretations between people and between

contexts could encourage switching to bright-line thresholds. For example, SFAS No. 109

defines “more likely than not” as “more than 50 percent probability” (paragraph 17c). However,

the psychology and accounting literatures indicate that such a change might not be effective in

reducing variance in interpretations, because people often struggle when estimating and

interpreting numerical probabilities. Wallsten et al. (1993) summarize psychological research

that uses inexperienced participants to perform generic tasks, and conclude that there is generally

little difference in outcomes of judgments made using numerical and verbal probabilities. In

accounting, the primary studies are set in the context of auditors’ evaluations of components of

the audit risk model. Participants in these studies provide risk ratings using their firms’ scale of

probability phrases, such as “low” risk or “moderate” risk. Researchers translate these ratings

into numerical probabilities, using either participants’ numerical definitions of the phrases or

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definitions provided by the auditing firm. Stone and Dilla (1994) use these techniques to provide

evidence that consensus in auditors’ risk judgment is higher when assessments are based on

numerical probabilities, while Reimers et al. (1993) and Dilla and Stone (1997) report that

consensus is higher when risk judgments are based on probability phrases. In general, this

research suggests that replacing probability phrases with numerical thresholds does not

materially enhance the accuracy with which standards communicate.

Number of Rules and Dimensions of Complexity

Another way to enhance the communication accuracy of a standard is to increase its

precision by including more rules. Standards can explicitly allow or disallow individual

accounting treatments or provide examples and detailed implementation guidance. For example,

SFAS No. 125 forbids de-recognition of liabilities through in-substance defeasance, and provides

numerous illustrations of appropriate implementation of the standard. These sorts of rules can be

included in the original standard, but also may accrete over time as precedents and guidance

accumulates. The problem with this approach to increasing precision is that it can increase the

complexity of the standard, thereby creating communication problems that offset the

communication benefits provided by increased precision.

Practitioners often complain that voluminous rules create such a “standards overload”

that very few practitioners are able to accumulate and absorb the complex information that

standard-setters are trying to communicate (Shaw 1995; Beresford 1999). Considerable research

examines how task complexity affects judgment; see Bonner (1994) and Tan et al. (2002) for

reviews. Task complexity generally harms judgment accuracy and consistency by encouraging

coping strategies that reduce mental processing, such as disregarding potentially important

information and combining information in simplistic ways. According to Wood (1996), total

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task complexity is determined by task characteristics that affect “component complexity,”

“coordinative complexity,” and “dynamic complexity.” In the context of applying financial

reporting standards, component complexity increases with the number of decisions to be made

and the number of precedents and examples to be considered. Coordinative complexity increases

when information must be combined in complex or unspecified ways when determining whether

a standard is satisfied. Dynamic complexity increases when the requirements necessary to

satisfy a standard shift over time.

Wood’s definition indicates that additional rules may increase or decrease task

complexity, depending on the circumstances. On the one hand, adding an exception or precedent

presumably heightens total task complexity. Component complexity increases with more rules,

coordinative complexity increases when a new rule must be considered in light of existing rules,

and dynamic complexity increases by changing the pattern of rules over time. On the other hand,

adding an implementation guideline that sequences the decisions necessary to implement a

standard, or adding an index that better relates existing rules and precedents, could lower total

task complexity by reducing coordinative complexity more than the addition increases

component and dynamic complexity.

Complexity may not reduce communication accuracy for all practitioners to the same

extent. Rather, prior experimental research indicates that practitioners who possess more

relevant knowledge, such as search strategies and indicators of information relevance, are better

able to cope with complexity (Bonner and Lewis 1990; Libby and Tan 1993). For example,

Asare and McDaniel (1996), Tan and Kao (1999) and Tan et al. (2002) all provide evidence that

auditors perform better on complex tasks when they have higher task-relevant knowledge and

ability. Cloyd (1995) finds that tax professionals who are more knowledgeable about tax rules

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are better able to quickly locate relevant rules, and Spilker (1995) reports that experienced tax

professionals are better than graduate tax students at identifying key words for use in searching

for relevant tax authority.

This finding that knowledge helps practitioners sift through relevant authority could

explain some of the outcomes of auditor/client negotiations reported by Nelson et al. (2002)

(hereafter, “NET”). NET surveyed 253 audit managers and partners, eliciting 515 descriptions

of earnings-management attempts that included the transactions involved, the relevant

accounting guidance, and the auditors’ decisions to either require adjustment of the attempt or

waive adjustment. The cell labeled “C” in Table 1 shows NET’s evidence that auditors are

relatively likely to require adjustment of their clients’ aggressive accounting when the client has

not structured transactions to comply with precise guidance as to appropriate treatment.4

Auditors often explained that these situations occurred because the client appeared unaware of

the relevant accounting rules. To the extent that auditors know more than their clients about the

relevant standards, or can consult more knowledgeable resources, they are better able to cope

with the complexity of the relevant accounting regulations and find guidance specific to client

circumstances.

(INSERT TABLE HERE)

Another role of structure in professional standards may be to assist practitioners in

drawing analogies. Standard setters recognize that, without precise rules, practitioners must

reason by analogy, mapping relations between elements of standards or examples to their own

decision problems (SAS No. 69, paragraph 9). Research in psychology and tax provides

evidence that this mapping depends on decision makers seeing through surface features of a

problem to identify the key relations that determine the structure of the analogy (Marchant et al.

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1993). These studies suggest that even standards with relatively few rules could benefit from

increased structure and carefully chosen examples that facilitate analogy development.

Communication: Summary

The research literature suggests that bright-line thresholds can be used in some

circumstances to communicate accurately. However, the more general way to increase the

precision with which a standard communicates is to increase the amount of specified decision

process, detailed implementation guidance, examples, precedents and other rules that are in the

standard. Although additional rules increase precision, they also increase various dimensions of

complexity, unless they reduce coordinative complexity by increasing structure. Standard setters

face a tradeoff between including too few rules and creating a standard that communicates too

vaguely and is interpreted inconsistently, versus including too many rules and creating a standard

that becomes so complex that parts of it are applied incorrectly or missed entirely.

CONSTRAINING AGGRESSIVE REPORTING

This section focuses on how rules affect a standard’s ability to constrain aggressive

reporting. By “aggressive” I mean reporting that is biased to produce an outcome consistent with

management’s incentives. Aggressive reporting could bias elements of the financial statements

either upwards or downwards, need not be “income increasing,” and could refer to balance-sheet

elements rather than income-statement elements. I focus on the effects of precision on

constraint, beginning with research evidence about behavior associated with precise standards,

and then discussing research evidence related to imprecise standards.

Constraining Behavior With Precise Standards

Little experimental research examines reporting choices under precise standards, but

auditor surveys provide some relevant evidence. The cell labeled “D” in Table 1 shows NET’s

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evidence that auditors are not likely to require their clients to adjust aggressive reporting that has

been specifically structured to meet precise standards, because the client can demonstrate

compliance with GAAP. These data highlight that precise standards can create targets that

managers use to achieve particular accounting objectives. Modifying transactions can be costly,

but in some circumstances managers appear to believe that the costs are justified. Auditors

responding to NET’s survey usually were reluctant to argue “substance over form” when a client

clearly complied with precise accounting criteria, even when those criteria were accompanied by

qualifiers indicating the criteria do not apply in all circumstances.

As mentioned previously under “communication,” one interpretation of the result in cell

“C” of Table 1 is that there are situations in which auditors know more about precise accounting

rules than do their clients, and therefore are better able to identify the specific rules and

precedents that prohibit a client-preferred accounting treatment. However, another explanation

is that auditors’ negotiating positions are particularly strong when they can point to precise rules

that preclude the client’s preferred accounting treatment. Consistent with this interpretation,

Gibbins et al. (2001) note in their survey of 93 audit partners that unambiguous standards

increase auditors’ power in auditor/client negotiations. Respondents identified the presence of

relevant accounting standards and the audit firms’ accounting expertise as key to successfully

resolving negotiations.

Overall, these survey studies suggest that a precise standard enhances the negotiating

position of either the auditor or the client, but whose position is strengthened depends on whether

the transaction is structured. These results imply that, when standard-setters decide whether to

increase the precision of a standard, they should weigh the benefits of precision that result from

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auditors rejecting more unstructured aggressive reporting against the costs of precision that result

from companies structuring aggressive transactions that auditors accept.

Prior experimental research suggests that precise standards are less effective in

constraining aggressive reporting when managers have latitude in interpreting the evidence

related to the standard. For example, Cuccia et al. (1995) find that professional tax preparers

respond to a more stringent tax practice standard by interpreting evidence more liberally, such

that decisions made under a more stringent standard are as aggressive as decisions made under a

less stringent standard (see also Johnson 1993). In fact, the justification process itself might

offer sufficient latitude, holding constant precision of standard and evidence. Kennedy et al.

(1997) provide evidence that auditors view their reporting choices as more justifiable even if

they only consult another partner, regardless of the aggressiveness of the decisions or the extent

to which they followed the partner’s advice. Thus, precise standards are more likely to help

auditors reject unstructured aggressive reporting when there is insufficient other latitude for the

client to justify their preferred position.

Constraining Behavior With Imprecise Standards

The top row of Table 1 reports NET’s survey evidence about aggressive reporting

attempted under imprecise standards. Cell “B” indicates that NET’s respondents identified

relatively few instances of structured aggressive reporting with respect to imprecise standards.

NET believe this finding is driven by the benefits of transaction structuring being less certain to

exceed the costs of structuring when the standard is not precise enough to insure auditor approval

of the structured transaction. Cell “A” indicates that NET’s respondents identified many

instances of unstructured aggressive reporting with respect to imprecise standards, and that

auditors in those circumstances waived adjustment of the transaction in 61% of the cases.

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Auditors often justified waiving these adjustments because (1) the transaction was subjective and

the auditor couldn’t prove the client’s position was incorrect, or (2) because the transaction

decreased current-year income and could be viewed as immaterial or conservative with respect to

the current year.

Consistent with these survey results, a relatively large experimental literature provides

evidence that the aggressiveness of reporting decisions increases with the imprecision of the

relevant reporting standard. This basic result has been produced under a variety of experimental

approaches, most of which focus on auditors’ role in constraining the aggressiveness of their

clients’ reporting.

Some studies report experiments in which experienced auditors determine appropriate

accounting under standards that differ in their precision. For example, Trompeter (1994) varied

the precision of accounting standards and evidence by presenting audit partners with three cases:

a marketable-security valuation case in which the client-preferred alternative was clearly

precluded, and two contingency cases in which SFAS No. 5 indicated the client’s position was

incorrect but arguable. Partners were more likely to allow a client’s income-increasing

accounting treatment in the cases governed by the less-precise standard. Similarly, Hronsky and

Houghton (2001) provide evidence that Australian auditors with an average of five years of

experience were less likely to allow extraordinary treatment under a new standard that required

explicitly that extraordinary items be of a nonrecurring nature.

Other studies manipulate in other ways the latitude available in the comparison between

standards and evidence. For example, Libby and Kinney (2000) examine audit managers’

decisions about quantitatively immaterial proposed adjustments by varying whether the

misstatement is subjective or objective and whether it is material qualitatively. Auditors did not

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require adjustment of either subjective or objective amounts if the adjustment produced a change

that was qualitatively material to their client. Salterio and Koonce (1997) examine audit

managers’ and partners’ decisions about proposed adjustments and vary the unanimity of

relevant precedents. Auditors tended to require their clients to make the reporting choice

indicated by precedents when the precedents unanimously favored one choice, but tended to

allow their clients to make more aggressive reporting choices when precedents were mixed. A

tax study by Marchant et al. (1993) considers analogical reasoning used by students and

experienced tax preparers when determining whether a court would allow a questionable tax

deduction. More experienced tax preparers were more likely to select a precedent based on a

poor analogy to their client’s situation when the analogy supported the client’s position. Ng and

Tan (2002) vary whether audit managers are told that authoritative guidance exists with respect

to a hypothetical revenue recognition problem. Auditors were more likely to allow the client’s

aggressive accounting when authoritative guidance was missing and the client’s audit committee

was weak.

Knapp (1987) performed an experiment that bears directly on whether audit committee

members would support auditors in a dispute with client management. Audit committee

members were less likely to support the auditors’ position in a conflict with management when

the relevant accounting rules were judgmental (operationalized as a dispute over the materiality

of an item) than when the relevant accounting standard was objective (operationalized as

mandatory disclosure of a subsequent event).

Several studies examine the effects of latitude in experimental markets in which students

play the role of auditors. These studies differ in how they operationalize latitude. The

experiments reported by Schatzberg et al. (1996) and Calegari et al. (1998) allow markets to vary

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according to the extent to which participants are told that auditors agree on the appropriate

accounting, while the experiments reported by Mayhew et al. (2001) vary the accuracy of the

evidence provided to participants. Results in these studies suggest that auditors are more likely

to misreport in the direction favored by their client when the appropriate accounting is uncertain.

Overall, these various experimental approaches provide evidence that the aggressiveness

of reporting decisions increases with the imprecision of the relevant reporting standards.

However, it is premature to conclude from these studies that reporting behavior is always more

aggressive under imprecise standards, because these studies focused on behavior in settings

where incentives tended to favor aggressive reporting.

Other experiments vary incentives and examine reporting behavior under imprecise

standards.5 For example, Farmer et al. (1987) find that experienced auditors’ reactions to a

client’s novel accounting approach were influenced by factors like potential for client loss and

potential for litigation. Hackenbrack and Nelson (1996) provide evidence that audit seniors’

interpretations of the SFAS No. 5 “reasonable estimate” requirement are more conservative for

clients that expose the auditor to higher risk of litigation and reputation loss. These studies

indicate that incentive-consistent interpretation of imprecise standards does not imply that

managers always prefer aggressive disclosure, or that auditors always agree with that preference.

Rather, the balance of incentives determines the directional effect on judgment (Lewis 1980).

Balancing Incentives Under Imprecise Standards

Changing the balance of incentives is likely to have a greater effect under imprecise

standards. Under precise standards, knowledgeable preparers may achieve a high probability of

having their auditors approve aggressive reporting by carefully structuring transactions,

regardless of general disincentives provided by regulators or courts. However, when the relevant

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standard is imprecise, the preparer must cope with uncertainty and ambiguity about outcomes. If

the penalties for aggressive reporting are sufficiently severe, preparers facing imprecise

standards presumably will report more conservatively to avoid risking those penalties.

Consistent with this perspective, Nelson and Kinney (1997) provide experimental evidence that

auditors respond to increased ambiguity about the probabilities relevant to a reporting decision

by reporting more conservatively than they do when the probabilities are stated precisely.

Zimbelman and Waller (1999) report similar findings with students role-playing auditors in

experimental games.

It is important to take a broad view of the features of the accounting setting that might tilt

the balance of incentives toward or away from aggressive reporting. The research literature has

focused for some time on auditor incentives based on concerns about client retention, litigation

exposure and potential consulting revenues, as in Carmichael and Swieringa (1968). However,

auditors can also face more subtle incentives. For example, Bazerman et al. (1997) suggest that

identification with their client’s situation might encourage auditors to allow aggressive reporting,

while King (2002) provides evidence that identification with an auditor peer group might

discourage aggressive reporting.

The balance of incentives can affect behavior unintentionally. For example, Wilks

(2002) and Beeler and Hunton (2002) examine “pre-decisional distortion” of audit evidence, in

which incentives affect how evidence is viewed, and therefore affect decisions in unintended,

unconscious ways. Both studies examine judgments of client financial-health indicators for

purposes of making a “going concern judgment.” Wilks’ (2002) results indicate that audit

managers are more likely to make going-concern judgments that agree with a partner’s

preliminary views, particularly when they are provided with those views prior to evaluating

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evidence. Beeler and Hunton’s (2002) results indicate that audit partners are more likely to rate

evidence as supporting continuance of a going concern when they need to retain their client

because they “low-balled” the initial audit fee or see high potential for future non-audit services.6

Similarly, when auditors anticipate that they will have to justify decisions to someone whose

preferences are known, experimental evidence suggests that auditors facilitate eventual approval

by biasing their search for information (Turner 2001), their weighting of evidence (Peecher

1996), and their audit opinions (Buchman et al. 1996) to be consistent with those preferences.

Finally, it is important to recognize that behavior can also be influenced by incentives

that encourage accurate judgment. When justifying the accuracy of decisions, auditors

document more relevant information (Koonce et al. 1995), avoid over-weighting recent

information (Kennedy 1993), identify more important information (Tan 1995), and perform

higher-quality ratio analysis (Ashton 1990; Tan and Kao 1999). Evidence that accuracy-oriented

justification requirements affect behavior suggests that incentives need not favor aggressive or

conservative reporting, but could be set to favor accuracy.

Constraint: Summary

The research literature indicates that, regardless of the precision of standards,

practitioners consciously or unconsciously make financial reports that are consistent with their

incentives. Precise standards appear to help auditors discourage aggressive reporting when

opportunities for transaction structuring are not available or clients are unaware of precise rules.

However, incentive-consistent reporting choices often can be justified with respect to precise

standards via transaction structuring or by aggressive interpretation of the evidence that is

evaluated and compared to standards’ requirements. And, if standards are imprecise, incentive-

consistent reporting choices can be justified via aggressive interpretation of standards. Thus,

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incentive effects should be viewed as pervasive. If standard-setters or regulators desire accurate

or conservative reporting, they are most likely to achieve it by combining (1) standards that are

imprecise enough to avoid precise safe harbors, thereby allowing incentive-consistent

interpretation to take place, and (2) vigorous enforcement activity that tilts the balance of

incentives away from aggressive reporting and towards accurate or conservative reporting.

CONCLUSION

The research literature suggests several broad conclusions about the incremental effects

of additional rules on a standard’s ability to communicate clearly and constrain aggressive

reporting.

First, a key to accurate communication is striking the right balance between providing

enough rules to communicate clearly and not so many rules that practitioners are overwhelmed.

Increasing the extent to which the various rules in a standard are related to each other should

help avoid overwhelming practitioners with complexity.

Second, a key to constraining aggressive reporting is the role of incentives in determining

behavior when latitude exists. When practitioners must choose between alternative accounting

or disclosure treatments, precise standards can offer safe harbors via transaction structuring, and

therefore may actually reduce regulators’ ability to constrain aggressive reporting. Instead,

aggressive reporting can be constrained by a combination of incentives for accurate or

conservative reporting and standards that are imprecise enough to offer no safe harbors.

Third, communication and constraint may operate at cross purposes under some

circumstances, since the detail necessary to communicate accurately can also create opportunities

for transaction structuring. In these cases, transaction structuring could be discouraged by basing

guidance more on examples than bright lines, and by including “substance over form” provisions

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that are enforced when transactions are structured in a manner that is inconsistent with economic

substance.

Many changes that are currently occurring or contemplated are consistent with the

implications of existing research. For example, the FASB is currently considering developing a

database to modify the FASB Current Text by referencing and including literature issued by

other standard-setting bodies, such as the SEC, EITF and AcSEC (FASB 10/24/2002). That

initiative should decrease the coordinative complexity inherent in existing standards. The FASB

is also proposing a more “principles-based” approach to standard setting which would involve

fewer rules and exceptions (FASB 2002). Included in their proposal is a potential “true and fair

view” override to require that the accounting for transactions reflect underlying economic

substance. These proposals should discourage transaction structuring and provide sufficient

latitude for incentives to affect behavior. Finally, the past few years have witnessed a dramatic

increase in public concern about aggressive reporting, as well as increased enforcement activity

by regulators. These changes could tilt the balance of practitioners’ various incentives towards

more accurate or conservative reporting. In combination with a move towards less of a rules-

based approach to standard setting, prior research suggests such a shift in incentives would

reduce the aggressiveness of financial reporting.

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 TABLE 1
Percentage of Attempts to Manage Earnings Adjusted By the Auditor,
By Precision of Accounting Standard and Transaction Structuring

Transaction Not Transaction

Structured Structured Total
Low Precision Cell A: 115/292 = 39% Cell B: 7/21 = 33% 122/313 = 39%
High Precision Cell C: 97/156 = 62% Cell D: 7/46 = 15% 104/202 = 51%
Total 212/448 = 47% 14/67 = 21% 226/515 = 44%

From Table 5 of Nelson et al.’s (2002) survey of auditor experiences with clients who were
attempting to manage earnings. Cell formats are: # attempts adjusted / total # attempts = %.
Precision of relevant accounting standard was coded as high if the standard used a quantitative
threshold or specifically allowed or disallowed the accounting treatment. An attempt was coded
as structured if it involved a change in the timing or nature of a contract, transaction or activity,
as opposed to involving a judgment or estimation process.

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 FOOTNOTES

1
See Imhoff and Thomas (1988) for a notable exception which provides evidence that managers

responded to the precise criteria contained in SFAS No. 13 by structuring lease arrangements to

qualify for operating lease treatment.

2
Caplan and Kirschenheiter (2002), Christensen et al. (2002), and Dye (2002) are recent

examples of theoretical studies in accounting that model various effects of the precision of

accounting standards. Kaplow (2000) reviews the law literature relevant to (1) interactions

between rule precision, rule complexity and uncertainty about eventual adjudication, and (2)

choosing the timing at which precision is provided.

3
I exclude from this review experimental studies which find that differences in accounting

method and/or disclosure format affect the judgments of various financial-statement users,

because such differences could arise from either principles- or rules-based standards. For

examples of these studies, see Dyckman (1964) and Hopkins (1996).

4
NET coded an accounting criterion relevant to an earnings-management attempt as “precise” if

the criterion (1) was quantified, consistent with “bright line” criteria increasing precision or (2) if

the criterion specifically allowed or disallowed the particular accounting treatment, consistent

with more rules increasing precision. They coded an earnings-management attempt as structured

if it involved a change in the timing or nature of a contract, transaction or activity, as opposed to

involving a judgment or estimation process.

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5
I focus on studies examining how incentives affect behavior, and exclude studies that examine

how variations in auditor incentives affect how independent they are perceived to be by various

constituencies. An example of the latter studies is Pany and Reckers (1988).

6
Phillips (2002) reports pre-decisional distortion of “going concern” evidence by accounting

students. He also provides evidence that the effect of incentives on interpretation of standards

happens more after decisions are made, to justify those decisions. This result is of interest

because it reduces concern that incentive-driven interpretations affect decisions. However, this

result may not generalize to experienced practitioners, who are better able to anticipate that their

decisions must be justified with respect to standards.

26