University of Iowa


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.


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.


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.

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

How do I calculate RBC?
1.
Identify characteristics of rules-based standards
2.
Determine if the characteristics are contained in the standard
3.
Add one point to the RBC measure for each characteristic the standard contains

FAS 13
• Fourteen exceptions
• Four bright-line thresholds
• Forty one interpretive releases
• 72,270 words
+1
+1
+1
+1
4
FAS 5
• Zero exceptions
• Zero bright-line thresholds
• Three interpretive releases
• 15,738 words
+0
+0
+0
+0
0


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 principlesbased than U.S. GAAP.

Untabulated factor analyses reveal that there is one underlying factor.


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.

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.

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 rulesbased 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.

 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 firmyear.

A Key-word dictionary was created using the following steps.
1.
Two co-authors independently read and reviewed each standard to identify potential key-words for each standard.
2.
These coauthors then discussed the potential key-word search terms for each standard and created a preliminary key-word search term dictionary.
3.
The key-word search term dictionary was sent the national office of one of the Big 4 firms.
4.
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.

A Keyword List was created using the following steps.
5.
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.
6.
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.


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”


We count how many times the keywords are mentioned in each firm’s 10-K.

We standardize the keyword counts:
𝑅𝐸𝐿_𝐼𝑀𝑃 𝑖𝑡𝑠
=
𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡 𝑖𝑡𝑠
− 𝑎𝑣𝑔_𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡 𝑡𝑠
(𝑓𝑖𝑟𝑚_𝑐𝑜𝑢𝑛𝑡 𝑡𝑠
)

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.


Multiply standard count score by RBC1 and sum across all standards for the firm.
𝑃𝑆𝐶𝑂𝑅𝐸 𝑖𝑡
= −1 ∗ 𝛴 𝑆 𝑠=1
𝑅𝐸𝐿
𝐼𝑀𝑃 𝑖𝑡𝑠
× 𝑅𝐵𝐶1 𝑡𝑠

Multiply by negative one to make measure increasing in principles-based standards.


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.

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.