Rules-Based Versus Principles-Based Accounting Standards Rick Mergenthaler University 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. One difficulty associated with this study is defining rules-based standards. The is no accepted definition of rules-based standards in the prior literature, but the several studies do describe the characteristics of rules-based standards. Schipper 2003 --“U.S. GAAP is based on a recognizable set of principles derived from the FASB's Conceptual Framework, but nonetheless contains elements that cause some commentators to conclude that U.S. accounting is ‘rules-based.’” The SEC describes rules-based standards in terms of these “elements,” which include (1) voluminously detailed implementation guidance, (2) numerous exceptions, and (3) numerous bright-line tests. Nelson 2003--Rules-based standards contain “relatively more elaborate rules.” I do not attempt to provide a normative definition of the “optimal structure of a standard,” but rather approach the issue from an empirical perspective. Consistent with Nelson (2003), I discuss the structure of standards “in terms of being more or less rules-based” where standards lie along a continuum. At the extremes of this continuum are standards that contain no rules-based characteristics and standards that contain many rules-based characteristics. Reasons why I don’t provide a definition of rules-based standards: Rules-based and Principles-based standards do not fit into two mutually exclusive categories. The complexity of the underlying transaction can affect the extent to which a standard contains “rules.” Standard setters balance the need for information that is relevant and reliable, while maintaining comparability.

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 I use several sources to determine the characteristics of rules-based standards. 2003 SEC Report “A Vision from the CEOs of the Internation Audit Networks” 2006 US House Financial Services Committee Meeting FASB 2002 Report I used these sources because they are experts on the topic. Based on this review, I identify several characteristics of rules-based standards. The characteristics I identified include: 1. The first characteristic of RBS is BLT. I define BLT as a numeric thresholds that delineates between two alternative ways to account for a particular transaction. I search each standard for key words to determine the number of BLTs in each standard: 1) criteri*, 2) condition*, 3) provision*, 4) require*, and 5) percent*” 2. The second characteristic of RBS is Scope and Legacy exceptions. I define scope an legacy exceptions as exclusions of certain transactions or exemption given to certain industries. I identify these exceptions by searching for the following words “1) not subject, 2) not consider*, 3) exclusion*, 4) exempt*, 5) except*, 6) scope, and 7) does not apply” 3. Third, I identify large volumes Implementation Guidance as a characteristic of RBS. In the summary of each standard, the SEC identifies “interpretive pronouncements.” I count the # of interpretive announcements to determine the total number implementation guidance documents in each standard. I then sort the standards by implementation guidance. I classify standards in the top “interpretive pronouncement” decile as standards with large volumes of implementation guidance. 4. Finally, I identify excessive Detail as a characteristic of RBS. I operationalize a high level of detail by counting the number of words in each standard. I then sort standards by the number of words in each standard. Finally, I classify standards in the top “detail” decile as high detail standards. I use these characteristics in my rules-based continuum measure. I outline these measures later in the presentation.

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

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 4 +0 Upper interpretive release decile is equal to 6 Upper detail decile is equal to 26,522

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 Cons 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. 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.

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.

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.

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.

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.

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