Principles-based Accounting Standards Research Articles

How do auditors’ use of industry norms differentially impact management evaluations of audit quality under principles-based and rules-based accounting standards?

Interactions between auditors and client management affect audit quality on an engagement because those interactions influence and incentivize auditor behavior and decision-making. I perform an experiment using 191 management participants to investigate (1) whether an auditor’s use of professional judgment or industry norms to justify proposed adjustments increases management’s evaluation of audit quality, and (2) whether these evaluations differ under principles-based or rules-based standards. I find that, although management views industry norms to be more credible, they disregard an auditor’s justification method and evaluate audit quality based on underlying accounting attributes when reporting under a more rules-based standard, such as US GAAP. However, when an accounting standard is more principles-based, such as IFRS, using industry norms positively influences perceptions of audit quality. Thus, when standards are less precise, auditors are incentivized to engage in herding behavior by defaulting to industry norms when determining appropriate accounting treatments. This study increases our understanding of the incentives and motivations faced by auditors in their interactions with client management under both rules-based and principle-based accounting standards.

Principles based accounting standards, audit fees and going concern: evidence using advanced machine learning

PurposeThe current study uses an advanced machine learning method and aims to investigate whether auditors perceive financial statements that are principles-based as less risky. More specifically, this study aims to explore the association between principles-based accounting standards and audit pricing and between principles-based accounting standards and the likelihood of receiving a going concern opinion.Design/methodology/approachThe study uses an advanced machine-learning method to understand the role of principles-based accounting standards in predicting audit fees and going concern opinion. The study also uses multiple regression models defining audit fees and the probability of receiving going concern opinion. The analyses are complemented by additional tests such as economic significance, firm fixed effects, propensity score matching, entropy balancing, change analysis, yearly regression results and controlling for managerial risk-taking incentives and governance variables.FindingsThe paper provides empirical evidence that auditors charge less audit fees to clients whose financial statements are more principles-based. The finding suggests that auditors perceive financial statements that are principles-based less risky. The study also provides evidence that the probability of receiving a going-concern opinion reduces as firms rely more on principles-based standards. The finding further suggests that auditors discount the financial numbers supplied by the managers using rules-based standards. The study also reveals that the degree of reliance by a US firm on principles-based accounting standards has a negative impact on accounting conservatism, the risk of financial statement misstatement, accruals and the difficulty in predicting future earnings. This suggests potential mechanisms through which principles-based accounting standards influence auditors’ risk assessments.Research limitations/implicationsThe authors recognize the limitation of this study regarding the sample period. Prior studies compare rules vs principles-based standards by focusing on the differences between US generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) or pre- and post-IFRS adoption, which raises questions about differences in cross-country settings and institutional environment and other confounding factors such as transition costs. This study addresses these issues by comparing rules vs principles-based standards within the US GAAP setting. However, this limits the sample period to the year 2006 because the measure of the relative extent to which a US firm is reliant upon principles-based standards is available until 2006.Practical implicationsThe study has major public policy suggestions as it responds to the call by Jay Clayton and Mary Jo White, the former Chairs of the US Securities and Exchange Commission (SEC), to pursue high-quality, globally accepted accounting standards to ensure that investors continue to receive clear and reliable financial information globally. The study also recognizes the notable public policy implications, particularly in light of the current Chair of the International Accounting Standards Board (IASB) Andreas Barckow’s recent public statement, which emphasizes the importance of principles-based standards and their ability to address sustainability concerns, including emerging risks such as climate change.Originality/valueThe study has major public policy suggestions because it demonstrates the value of principles-based standards. The study responds to the call by Jay Clayton and Mary Jo White, the former Chairs of the US SEC, to pursue high-quality, globally accepted accounting standards to ensure that investors continue to receive clear and reliable financial information as business transactions and investor needs continue to evolve globally. The study also recognizes the notable public policy implications, particularly in light of the current Chair of the IASB Andreas Barckow’s recent public statement, which emphasizes the importance of principles-based standards and their ability to address sustainability concerns, including emerging risks like climate change. The study fills the gap in the literature that auditors perceive principles-based financial statements as less risky and further expands the literature by providing empirical evidence that the likelihood of receiving a going concern opinion is increasing in the degree of rules-based standards.

The effects of cognitive reflection and work experience on financial statement comparability under principles-based accounting standards

ABSTRACTThis study examines the influence of cognitive reflection and work experience on certified public accountants’ (CPAs’) classifications of assets and cash flows under principles-based accounting standards and, ultimately, on the comparability of the resulting financial statements. We explore the overlapping guidance provided by the International Financial Reporting Standards on audiovisual content (AVC) classifications to experimentally show that CPAs who are high (versus low) in cognitive reflection make less noisy choices when classifying assets and cash flows. CPAs high in cognitive reflection are also more likely than others to recognise cash flows from AVC assets as operational regardless of the asset classification. We also find that experience in listed, large, or audited firms reduces noise in CPAs’ classifications of cash flows, but it is unlikely to affect their classifications of assets.

Corporate Monitoring and Misreporting: The Role of Rules-Based and Principles-Based Accounting Standards

SUMMARY Prior research provides some evidence that strict corporate monitoring constrains financial misreporting. We examine whether the efficacy of various corporate monitoring mechanisms hinges on the nature of accounting standards—rules-based standards (RBS) versus principles-based standards (PBS)—in place. We generally document that the negative association between the likelihood of misstatements and tough monitoring by audit committees, boards, external auditors, and the SEC is more pronounced under RBS than under PBS. This evidence collectively suggests that most corporate gatekeepers fulfill their monitoring obligations primarily through ensuring better compliance with detailed standards when the applicable standards are more specific and leave less room for discretion. Although some prior studies document higher financial reporting quality under PBS, our results imply that it is important for regulators to also consider the potentially higher monitoring efficacy under RBS when setting accounting standards. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M40; M42.

Principles-based standards and accountants’ financial reporting judgments: does work experience matter?

Purpose The purpose of this study is to examine accountants’ application of principles-based accounting standards to a lawsuit contingency recognition scenario and the potential role that accounting work experience plays in mitigating accountants’ aggressive financial reporting. Design/methodology/approach This study presents a 2 × 2 between-subjects experiment with accounting experience (measured as high vs low) and contingency type (asset vs liability) as independent variables and accountants’ lawsuit contingency conservatism likelihood judgments and US$ recognition recommendations as the dependent variables. Findings Consistent with expectations, findings indicate that more experienced accountants are more likely to recognize liabilities and items that decrease income and less likely to recognize assets and items that increase income than their less experienced counterparts. Accountants also recommended recognizing lower (higher) mean US$ amounts for assets (liabilities), as expected. Supplemental analyses show a significant moderated-mediated effect whereby the interactive effect of contingency type and accounting experience on individuals’ US$ recognition recommendations is partially mediated through the nature of the conservatism judgment. Practical implications The finding that less experienced accountants report more aggressively than more experienced accountants when applying a principles-based standard supports the call for using judgment frameworks in imprecise standard settings and suggests that firms may want to ensure that accountants with adequate work experience are on hand as U.S. generally accepted accounting principles become more principles-based over time. Originality/value To the best of the authors’ knowledge, this study is the first to examine the impact of accounting work experience on the application of principles-based accounting standards and the mitigation of aggressive financial reporting. Our supplemental analyses also identify the nature of the conservatism judgment as a mediating mechanism which partially explains more experienced accountants’ US$ asset and liability recognition recommendations.

Service performance reporting and principles-based authoritative guidance: an analysis of New Zealand higher education institutions

PurposeThis paper aims to examine the extent to which performance indicators (PIs) reported by New Zealand (NZ) higher education institutions (HEIs) correspond with accounting standards and guidance and the effects issuance of principles-based authoritative guidance and early adoption of Public Benefit Entity Financial Reporting Standard 48 (PBE FRS 48) have on the PIs disclosed.Design/methodology/approachUsing a content analysis index derived from accounting standards and guidance, we conduct a longitudinal assessment of the 2016 and 2019 statements of service performance published by 22 NZ HEIs.FindingsThe PIs reported extend beyond the service performance elements proposed by standard-setters. Despite few indicators on intermediate and broader outcomes, the measures disclosed by HEIs are reflective of their role in the NZ economy and the national Tertiary Education Strategy. The results show that principles-based authoritative guidance and early adoption of PBE FRS 48 influence the focus and type of measures disclosed, while there is no evidence of improvements in the reporting of impacts, outcomes and information useful for performance evaluation.Practical implicationsThis paper provides timely insights for standard-setters and regulators on the influence principles-based accounting standards and guidance have on non-financial reporting practices.Originality/valueThis study contributes to the scant literature on HEIs’ service performance reporting. It presents a model for conceptualising HEIs’ PIs that can be used as a basis for future research on non-financial reporting. It also reflects on the tension between accountability and “accountingisation”, suggesting that, although the PIs reported support formal accountability, they do not communicate whether HEIs’ activities and outputs meet their social purpose.

Are We Moving Towards Principles-Based Accounting Standards: Evidence from Four East Asian Countries

Are We Moving Towards Principles-Based Accounting Standards: Evidence from Four East Asian Countries

The effect of the rules- versus principles-based accounting standards on opinion shopping

PurposeThe purpose of this study is to examine whether the change in accounting standards from the rules-based local GAAP to the principles-based IFRS influences a manager’s opportunistic auditor choice for a favorable audit opinion, opinion shopping (OS) behavior. The authors view that IFRS adopters exploit the flexibility of IFRS to their advantage and search for auditors that are more likely to give clean opinions. However, auditors may refuse to yield to client pressure for OS, because of the greater potential audit risk under principles-based standards.Design/methodology/approachThis study applies a difference-in-differences methodology by using Korean listed firms (i.e. IFRS adopters) as a treatment sample and Korean unlisted firms that do not voluntarily adopt IFRS (i.e. K-GAAP users) as the control sample. OS behavior is measured by the methodology of Lennox (2000).FindingsThe results of this study show that the OS behavior of IFRS adopters increases after IFRS adoption compared to that of K-GAAP users. This phenomenon is more prevalent when they are audited by non-Big 4 auditors or when they are economically important to auditors. These suggest that the principles-based IFRS without specific rules increase the scope of OS, and auditors tend to accept OS clients by weighing up its costs and benefits.Originality/valueThis study contributes to the literature on OS by presenting that the approach of accounting standards can be an important influencing factor on a firm’s successful engagement in OS. This finding also provides policy implications for many economies by suggesting mechanisms that can be developed to reduce clients’ opportunistic auditor choices under principles-based accounting standards.

Shifting from the incurred to the expected credit loss model and stock price crash risk

Using a difference-in-differences (DID) design, this study examines the effect of shifting from the incurred credit loss model (ICL model) to the expected credit loss model (ECL model) on banks’ future stock price crash risk. We find that switching to the ECL model decreases the stock price crash risk of commercial banks. Inspired by Onali et al. (2021), we proceed with cross-sectional tests from the perspectives of opportunistic incentives, information environments, and compliance costs and find that the effect is more pronounced for (i) banks with less opportunistic incentives, proxied by state-owned property rights and managerial ownership; (ii) banks with opaque internal and external information environments, proxied by weak internal control, weak board governance, low analyst coverage, and short auditor tenure; and (iii) banks with lower implementation costs, proxied by less day-one impact and higher levels of accounting conservatism. Channel analyses show that banks increase their asset impairment provisions and the timeliness of loan loss recognition, and there is an increase in the value relevance of earnings and bank efficiency after the adoption of the ECL model. Overall, our evidence suggests that the flexibility of principle-based accounting standards influences banks’ stock price crash risk and provides implications that could be helpful to regulators and standard setters.

Principles-based accounting standards and audit outcomes: empirical evidence

Principles-based accounting standards and audit outcomes: empirical evidence

Principles-based accounting standards and the timeliness of annual reports: evidence from China

PurposeThis paper addresses the role of principles-based accounting standards as a potential mechanism for reducing firms' time delay of annual reporting disclosure while improving the timeliness of accounting information. The paper also contributes to the existing literature by addressing the mediating effects of the financial reporting complexity and the audit workload on the link between principles-based accounting standards and the time delay of annual reporting disclosure.Design/methodology/approachThe focus is placed on an unbalanced panel of 20,943 samples over the period of 2007–2017.FindingsThe results show that the more principles-based the accounting standards are, the lower the time delay of annual reporting disclosure is, and the timelier the disclosure of accounting information is. The relationship between the two is more significant especially in the first two months after the end of the fiscal year. The findings are all robust after controlling for a series of sensitivity checks and endogenous concerns. From the mediating effect results, the authors find that principles-based accounting standards decrease the financial reporting complexity and the audit workload which in turn can help lower time delay of annual reporting disclosure. In addition, the negative effect of principles-based accounting standards on the time delay of annual reporting disclosure is more significant in the case that the company has “good news” including with no losses and receiving the standard auditing opinions. The results confirm the law of “good news announces early, bad news announces late.” Furthermore, the moderating effect results show that the higher the economic policy uncertainty index and the legal environment index, the lower the benefit of principles-based accounting standards to the timeliness of annual reports. The results of the economic consequences of timeliness suggest that the timely disclosure of accounting reporting will bring greater market reaction and contain more information, and the information of companies that disclose annual reports timely are more transparent.Originality/valueThis paper studies the impact of accounting standards on the timeliness of annual report disclosure, which enriches the literature in the field of macro policies and micro-enterprise behaviors.

Standard precision and aggressive financial reporting: the influence of incentive horizon

The extant literature on precision in accounting standards suggests that financial statement preparers are less likely to make aggressive financial reporting decisions under less precise, principles-based accounting standards as compared to under more precise, rules-based accounting standards. We extend this line of research by examining how the incentive horizon of financial statement preparers influences earnings management behaviour. Consistent with prior literature, we find evidence that more precise standards lead to more income-increasing earnings management behaviour than do less precise standards when the incentive horizon is short-term in nature. However, when the incentive horizon is long-term, more precise standards are associated with financial reporting decisions that reduce current income relative to less precise standards. Importantly, the findings demonstrate that the effects of standard precision are changed by the incentive time horizon, and the effects of standard precision on financial decision makers cannot be fully understood when precision is studied without considering the timing of management incentive structures.

Principles-Based Accounting Standards and Audit Outcomes: Empirical Evidence

The purpose of this study is to empirically examine the relations between audit outcomes and accounting standard design (principles-based vs. rules-based) for U.S. firms. Considering that audit outcomes may vary with audit risk which may differ under different accounting standards, we examine and find that audit risk and audit fees are lower when client firms rely more on principles-based standards. Next, we find that principles-based standards are associated with lower likelihood of receiving a going concern opinion and shorter audit report lag. However, for firms that rely more on principles-based standards and, have greater incentives to engage in earnings management, audit fees are higher. Collectively, our results inform the FASB, the SEC, and the PCAOB of the potential benefits of using principles-based standards with respect to audit outcomes and more broadly, provide evidence on the role that accounting standard design plays in auditing.

The principles underlying the IFRS and the measurement bases of the elements comprising the financial statements

Purpose: This theoretical essay seeks to present concepts, arguments and discussions about the adoption and use of IFRS, focusing on their underlying principles and measurement bases.
 Methodology: Literature review with presentation and discussion of arguments from authors who have researched the use of IFRS and its underlying principles and measurement bases.
 Results: Principle-based accounting standards are seen by a number of authors as a possible solution to the problem of accounting harmonization. However, another stream of authors states that principle-based accounting standardization, although it may result in higher quality it is less assertive financial reporting, given the existence of subjectivity in the content of financial statements. This fact leads to the conclusion that absolute harmonization of accounting standards would be impossible.
 Contributions of the Study: The study proposes notes regarding the discussion on IFRS, which are responsible for increasing the quality of financial statements, while at the same time reducing the reliability of the information produced, in view of the difficulties inherent to the application of the concept of fair value.

Principles-Based Accounting Standards, Earnings Management and Price Efficiency

The issue of principles-based accounting standards has been attracting growing interest since the emergence of the International Financial Reporting Standards (IFRS) as a global phenomenon, and the United States consideration of IFRS adoption. This paper studies the effect of a move towards principles-based accounting standards on price efficiency in the equity market. I assume a move towards principles-based standards requires the firm’s manager to use more of his private, though more subjective, information for financial reporting. I model the manager’s reporting decision as a trade-off between increased compensation through earnings management and a cost associated with earnings management (such as litigation, SEC enforcement, and manipulation effort). I find that the effect of a move towards principles-based accounting standards on price efficiency is non-monotonic. When standards are highly rules-based, reducing the use of rules-based standards increases price efficiency. However, at some point, this relation reverses. The optimal mix of rules and principles reflects a trade-off between two types of effects on price efficiency: predictive ability and comparability. In addition, expected earnings management is non-monotonic in the use of rules-based standards. Finally, I find that rules intensity and managerial compensation incentives act as complements, such that higher managerial compensation incentives require more rules-based standards for price efficiency to be maximized.

The Social Construction of Accounting Reality: Translation of a Principles-Based Discourse

Purpose—Applying the concept of translation, this study aims to develop an understanding of how the principles-based discourse emerged and became rule-like social facts and thus constructed an accounting reality in a particular regulatory space. Design/methodology/approach—This study focuses on various stakeholders’ discourses. The material and analysis presented in this paper derive from an extensive review of congressional documents, official reports, consultation documents, comment letters, and a range of additional information available on the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) web pages, as well as related academic papers. Findings—The “principles-based” concept was originally introduced to describe the features of International Financial Reporting Standards (IFRS), in contrast with the “rules-based” concept. Through the principles-based versus rules-based debate in the early 2000s, the following accounting reality was temporarily constructed: IFRS is principles-based and US Generally Accepted Accounting Principles (GAAP) rules-based, and the principles-based accounting standards (PBAS) are more relevant and useful in decision-making. That is, the principles-based discourse and its recurring narrative provided a rational account and moral basis for a comparative advantage of IFRS. Originality/value—In line with the existing discourse-related accounting literature, this study focuses on the principles-based discourse and analyzes its critical roles in the process of accounting change. It also shows how the US SEC and the FASB played essential roles in the translation process that constructed the US accounting reality. Furthermore, this historical case sheds light on how local actors react to changes and shows how scandals, a historical contingency, became an impetus for accounting changes.

The Improbability of Fraud in Accounting for Derivatives: A Case Study on the Boundaries of Financial Reporting Compliance

ABSTRACTThis study responds to recent calls in the literature to examine fraud using detailed case studies, extending knowledge beyond individual incentives and capital market reactions towards a more contextualized understanding of the concept. We use an institutional logics perspective to challenge existing assumptions about a universally valid meaning of compliance, fraud, and faithful representation. Presenting the case of the Swedish bank HQ, we show how the interpretation of the accounting standard for option measurement varies across different enforcement bodies because the meaning of compliance is socially negotiated across the institutional logics of markets, financial regulation, and law. The independent decision-making of the different enforcement bodies leads to a systematic variation in the interpretation of principles-based accounting standards without ultimate coordination. To define consistent boundaries of compliance across institutional logics, and thus, to distinguish between fraud and allowable managerial discretion becomes problematic. Faithful representation, in turn, cannot be understood as financial statements reflecting a correct value or as financial statements being prepared in accordance with acceptable practice, as suggested in the earlier literature. Instead, faithful representation itself becomes a contextually bound concept, which can only be defined within an institutional logic.

Examining Often-Heard Allegations: Is U.S. GAAP More Rules-based than IFRS?

Following the massive wave of high-profile accounting scandals at the beginning of this millennium, there has been an apparent consensus within the U.S. policy-making circles that the existing U.S. accounting standards are the main reason for these failures. Many assert that U.S. GAAP is rules-based, with a main focus on meeting the form rather than the substance of accounting transactions. Consequently, the United States of America has witnessed increasing calls to abandon the current allegedly “rules-based” accounting system in favor of a principles-based system. As a result, the U.S. FASB adopted a best efforts convergence approach with the IASB (widely known as a provider of principles-based accounting standards) in September 2002. However, no prior research examines the extent to which rules-based characteristics exist in U.S. GAAP or IFRS. The objective of our study is to investigate if there is a significant difference in rules-based characteristics between U.S. GAAP and IFRS. To address this research question, we develop our own principles-versus-rules continuum instrument to quantitatively measure the extent to which rules-based characteristics exist in U.S. GAAP and IFRS. We find that inconsistent with the often-heard allegations, U.S. GAAP is less rules-based (more principles-based) than IFRS. For robustness, we confirm our results using the rules-based instrument developed by Mergenthaler (2009). Our empirical results will provide significant inputs to regulators and standard setters in their ongoing deliberations on how to improve the standard-setting process.

The importance of professional judgement applied in the context of the International Financial Reporting Standards

Guidance has always been welcome in terms of applying professional judgement in the context of the principles-based accounting standards – International Financial Reporting Standards. This fact is the result of the complexity and diversity of some situations, which might give rise to difficulties in terms of choosing the appropriate accounting policies and methods (depreciation, inventory valuation on hand at the end of an accounting period, the recognition of revenues and expenses from a construction contract, accounting for lease contracts by the proper determination of the type of lease: financing or operating), and respectively the need to verify if the criteria set by the principles-based accounting standards are met. This “freedom” of choice and disclosure might create problems in terms of accounting information quality. The possibility to select accounting methods based on the Standards’ provisions is meant to generate a true and fair view of the company’s financial position and financial performance. In these cases it is recommended to use professional judgement in order to reach a conclusion which is in accordance with the accounting principles and is not enforced by any accounting rules, since the exercise of individual professional judgement is preferred against the “pure” compliance with prescriptive legal requirements.

The interpretation differences of verbal probability expressions in principles-based accounting standards: evidence from China

This study examines whether verbal probability expressions (VPEs) in principles-based accounting standards are understood and interpreted consistently by Chinese accounting professionals and students. We gathered data from auditors working in Chinese public accounting firms, accounting professionals not employed by Chinese public accounting firms, and Chinese accounting students. The results indicate that Chinese auditors exhibit a high degree of consensus in their VPE interpretations. However, preparer and student interpretations tend to vary more and exhibit lower levels of consensus. In addition, there are evidences showing that small differences in the translation of VPEs can have a significant unintended impact on the interpretations of these expressions in accounting standards.