When Less is More: The Effect of Reducing Auditor Liability on Auditor Judgments in Principles-Based and Rules-Based Environments

Abstract

The purpose of this paper is to investigate the joint effects of accounting guidance type (principles-based versus rules-based) and legal liability regime (unlimited versus limited) on auditor decisions. Both the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) believe that moving to more principles-based standards in the United States will allow companies and auditors to more appropriately reflect the economic substance of transactions in the financial statements. However, very little attention has been paid to the possibility that principles-based standards will be applied differently in the United States than in other countries due to a different legal regime. This paper explores how different legal liability regimes impact auditor judgments in principles-based and rules-based environments. Results suggest that auditors' decisions differ based on the type of accounting guidance, and regulators may want to consider this when evaluating a potential change in standards. In my study, I predict and find that when the economic substance of a transaction suggests that the relatively more aggressive accounting treatment is appropriate, auditors make decisions most consistent with economic substance under a combination of principles-based guidance and limited auditor liability.