Accounting Scandals: Does “Rules vs. Principles” Matter?
By Alexis V. Nisbett and Aamer Sheikh, Ph.D., CPA , CBM
Recent developments have
increased the likelihood that U.S.
regulators may permit the use of
International Financial Reporting
Standards (IFRS) as well as (or perhaps
in place of) Generally Accepted
Accounting Principles (U.S. GAAP)
in the near future. On April 24, the
Securities and Exchange Commission
(SEC) announced that it will consider
allowing domestic companies to choose
which type of accounting standards
to follow in reporting their financial
performance.1 In addition, President
Bush signed an agreement with the
European Union on April 30 that will
“seek to ensure conditions for the
U.S. Generally Accepted Accounting
Principles and International Financial
Reporting Standards to be recognized
in both jurisdictions without the need
for reconciliation by 2009 or possibly
sooner.”2 According to a recent
article in The Wall Street Journal, this
agreement could provide the motivation
for American companies to drop U.S.
GAAP for IFRS since the IFRS are
widely viewed as being more flexible or
“principles-based” whereas U.S. GAAP
are often viewed to be more rigid or
“rules-based.”3
This study compares rules-based
versus principles-based accounting
standards across eight countries that
reported accounting scandals to see
if any association exists between the
type of accounting standards and the
incidence of corporate and accounting
fraud.
RULES-BASED GAAP VERSUS
PRINCIPLES-BASED GAAP
IFRS are widely regarded to be
more principles-based than U.S. GAAP.
These principles-based accounting
standards emphasize the spirit of
the accounting rules rather than
strict adherence to a set of written
requirements. Mano, Mouritsen
and Pace describe an April 2003
advertisement by the accounting firm
PricewaterhouseCoopers in The Wall
Street Journal where the firm claimed
that:
Rules-based systems encourage
creativity (and not the good kind) in
financial reporting. They allow some to
10
Tennessee CPA Journal
|
NOVEMBER 2007
stretch the limits of what is permissible
under the law, even though it may
not be ethically or morally acceptable.
A principles-based system requires
companies to report and auditors to
audit the substance or business purpose
of transactions; not merely whether
they can qualify as acceptable under
incredibly detailed or overly technical
rules … A rules-based system allows
managers to ignore the substance and,
instead ask, “Where in the rules does it
say I can’t do this?”4
More recently, Benston, Bromwich,
Litan and Wagenhofer point out that:
…the rules-based U.S. accounting
standards have been blamed for
allowing and even encouraging
opportunistic managers to structure
transactions to produce misleading
financial statements that their IPAs
[Independent Public Accountants]
would have to or could attest did “fairly
present the financial conditions of the
corporation in accordance with generally
accepted accounting principles.” In
particular, with respect to Enron, the
audit firm Arthur Andersen was charged
with designing financial instruments
that met the technical requirements of
GAAP while violating the intent. Public
disclosure of Enron’s procedures has
given rise to a renewed debate over
whether accounting standards should be
based on rules or principles.5
However, as Katherine Schipper,
a former member of the Financial
Accounting Standards Board (FASB)
points out, it is not that U.S. GAAP
are not based on any principles, but
rather that U.S. GAAP contain certain
elements like detailed implementation
guidance that makes them appear rulesbased. In practice, one may argue that
the detailed implementation guidance
fosters an alleged current “checkthe-box” or compliance mentality to
financial reporting that reduces the
role of professional judgment in the
application of the reporting rules.6 As a
result, opponents of U.S. GAAP suggest
that moving to a more principles-based
system is desirable, because such a
system would encourage greater exercise
of professional judgment by accountants
and auditors.
COUNTRIES REPORTING
ACCOUNTING SCANDALS
Starting with the list of 30 countries
used by the Ding, Hope, Jeanjean and
Stolowy (2007) study, we then crosschecked this list of 30 countries to
the IAS Plus Web site, maintained by
Deloitte, which provides comprehensive
information about international financial
reporting.7 More specifically, this Web
site summarizes the use of IFRS as
the primary GAAP for reporting by
domestic companies by country and
region (available at www.iasplus.com/
country/useias.htm). Based on this table,
20 countries are classified as following
IFRS, the United States as the only
country that follows U.S. GAAP and
the remaining nine countries (Canada,
India, Indonesia, Japan, Republic of
Korea, Malaysia, Pakistan, Thailand and
Taiwan) as following neither IFRS nor
U.S. GAAP.
Only eight countries report
accounting scandals during the
2001-2005 period. These include the
United States, that follows rules-based
accounting standards, and seven
countries which follow the more
principles-based IFRS: Australia,
France, Ireland, Italy, the Netherlands,
Switzerland and the United Kingdom.
Thus, 13 countries which follow IFRS but
did not report any accounting scandal
during this period are excluded: Austria,
Belgium, Denmark, Germany, Greece,
Hong Kong, Norway, Philippines,
Portugal, Singapore, South Africa, Spain
and Sweden. Figure 1 describes the
classifications of the remaining eight
countries.
In order to ensure that only
scandals that were caused by an
accounting irregularity (like overstating
revenue by recording fictitious sales)
rather than scandals caused by other
reasons (for example, insider trading) are
included, we identify the source of the
accounting irregularities for each of the
companies by utilizing various databases
including Lexis-Nexis, ProQuest,
Stanford Law School’s Securities Class
Action Clearinghouse (available at
securities.stanford.edu) and the SEC’s
Accounting and Auditing Enforcement
Releases (AAERs). For each corporate
scandal identified, information relating
to the main business sector in which the
company operated and the year in which
the scandal became public knowledge is
obtained.
Technologies, Mirant, NextCard, Peregrine
Systems, Refco, Teltran International and
WorldCom. Global Crossing also went
bankrupt, but it was the deterioration of its
underlying business
Figure 1: Countries Reporting Accounting
rather than financial
During the Period 2001 - 2005
misreporting that
was the primary
Rules-Based GAAP
Principles-Based GAAP (or IFRS)
cause.8 The financial
misreporting was
Australia, France, Ireland, Italy,
United States
Netherlands, Switzerland, United Kingdom typically caused by
improper revenue
recognition and/or improper expense
recognition.
INCIDENCE OF ACCOUNTING
The magnitude of the scandals at
SCANDALS DURING
three companies (or 25 percent) using
2001-2005
principles-based standards, namely,
Table 1 (see page 12) lists each of
HIH Insurance, Parmalat and Cirio
the corporate accounting scandals and
Finanziaria, was sufficient to trigger
whether they occurred under rules-based
bankruptcy proceedings. The nature of
U.S. GAAP or the more principles-based
the misreporting was rather dispersed,
IFRS.
including improper revenue recognition,
During the five-year period 2001 to
improper expense recognition, improper
2005, accounting scandals at 38 companies
accounting in connection with business
became public knowledge under the U.S.
combinations and direct violations of
rules-based GAAP system as compared
accounting principles. Additionally,
to only 12 companies under the more
the role of American influence was
principles-based IFRS system. Thus,
evident in two of the 12 companies
during the period 2001 to 2005, more than
(Royal Ahold and Alstom). Not only did
three times as many accounting scandals
these two companies have U.S. stock
were reported in the United States than
exchange listings, but their accounting
in principles-based jurisdictions. This
problems originated with their American
result holds, even if we consider the total
subsidiaries.9 Thus, it appears that the
number of publicly-listed corporations in
magnitude of the misreporting triggered
these eight countries.
a relatively higher number of bankruptcy
There are approximately 6,811
filings under U.S. GAAP as compared to
companies publicly listed in the United
IFRS.
States versus approximately 6,892
Prior research also suggests that lax
companies listed in the seven principlesenforcement of IFRS may result in limited
based countries. During the period 2001compliance with IFRS, thereby limiting
2005, 38 out of approximately 6,811, or
their effectiveness.10 One wonders whether
0.56 percent, of listed companies reported
the lower number of reported accounting
instances of financial misreporting in
scandals under the seven principlesthe United States, while only 12 out of
based (international) regimes is partially
approximately 6,892, or 0.17 percent,
due to looser enforcement of accounting
of listed companies reported instances
standards in countries outside the United
of financial misreporting in the seven
States.
principles-based countries. All other
things being equal, this suggests that a
higher incidence of corporate accounting
fraud occured inside the United States as
compared to outside the United States.
The magnitude of the accounting
scandal was sufficient to trigger filings
for Chapter 11 bankruptcy at 12 of the 38
companies (or 31.6 percent) following U.S.
GAAP, namely, Adelphia, Ashford.com,
Delphi, Enron, Homestore.com, Liberate
CONCLUSION
The results of the study show a
higher incidence of corporate accounting
fraud occurs in rules-based United States
as compared to the more principlesbased countries. However, variation in
enforcement levels and other cross-country
differences like legal environment and
corporate governance structure may bear
on the quality of information produced by
financial reporting conventions in different
countries.11 It is possible that a lower
number of accounting scandals have been
reported in IFRS countries due to these
cross-jurisdictional differences. Even so,
the results of this study raise the question
of whether the use of more principlesbased accounting standards would lead to
a lower incidence of financial misreporting
in the United States. n
Endnotes
1. Securities and Exchange Commission. SEC
announces next steps relating to International
Financial Reporting Standards. April 24, 2007.
www.sec.gov/news/press/2007/2007-72.htm.
2. The White House. Framework for advancing
transatlantic economic integration. April
30, 2007. www.whitehouse.gov/news/
releases/2007/04/20070430-4.html.
3. Reilly, D. “What’s better in accounting, rules or
‘feel’?” The Wall Street Journal. April 30, 2007
pp. C1.
4. Mano, R., Mouritsen, M., and Pace, R.
“Principles-Based Accounting: It’s not new, it’s not
the rule, it’s the law.” The CPA Journal, Vol. 76
(2006) pp. 60-63.
5. Benston, G., Bromwich, M., Litan, R., and
Wagenhofer, A. Worldwide Financial Reporting: The
development and future of accounting standards.
Oxford University Press. (New York, NY, 2006).
6. Schipper, K. “Principles-Based Accounting
standards.” Accounting Horizons, Volume 17
(2003) pp. 61-72.
7. Ding, Y., Hope, O., JeanJean, T., and Stolowy,
H. “Differences between domestic accounting
standards and IAS: Measurement, determinants and
implications.” Journal of Accounting and Public
Policy, Vol. 26 (2007) pp. 1-38.
8. Grant, R., and Visconti, M. “The strategic
background to corporate accounting scandals.”
Long Range Planning Journal, Vol. 39 (2006) pp.
361-383.
9. Ibid
10. Ball, R., Kothari, S., and Robin, A. “The effect
of international institutional factors on properties of
accounting earnings.” Journal of Accounting and
Economics, Vol. 29 (2000) pp. 1-51.
11. Ruland, W., Shon, J., and Zhou, P. “Effective
controls for research in international accounting.”
Journal of Accounting and Public Policy, Vol. 26
(2007) pp. 96-116.
About the Authors:
Alexis V. Nisbett is a graduate student at Quinnipiac
University. She can be reached at alexis.nisbett@
quinnipiac.edu. Aamer Sheikh, Ph.D., CPA, CBM
is an assistant professor of accounting at Quinnipiac
University. He can be reached at aamer.sheikh@
quinnipiac.edu.
See table on page 12
Tennessee CPA Journal
|
NOVEMBER 2007
11
Table 1: Rules-Based vs. Principles-Based Accounting Standards & the Incidence of
Corporate Financial Misreporting During the Period 2001 - 2005
Rules-Based GAAP
Company
Main Business
United States
Year
Company
Australia
Main Business
Year
Adelphia
Cable & Telecom Services
2002
AIG
Insurance & Financial Services
2004
AOL Time Warner
Media
2002
Ashford.com
Retail Services
2001
Vivendi Universal Media & Telecommunications
2002
Bristol-Myers Squibb
Pharmaceuticals
2002
Alstom
2003
Broadcom
Semiconductors
2001
CMS Energy
Gas & Power
2002
Ireland
Computer Associates
IT Management Software
2002
Elan
Critical Path
Business Services
2001
Delphi
Electronics & Transportation
2004
Duke Energy
Gas & Power
2002
Parmalat
Food Processing
2003
Dynegy
Oil & Gas
2002
Cirio Finanziaria
Food Processing
2002
El Paso Corporation
Gas & Power
2002
Skandia
Financial Services
2003
Enron
Gas & Power
2001
Exxon
Energy & Petrochemical
2001
Fannie Mae
Mortgage Financing
2004
Royal Ahold
Freddie Mac
Mortgage Financing
2003
Royal Dutch Shell Energy & Petrochemical
Global Crossing
Telecommunications
2002
Halliburton
Technical services, Construction
2002
Healthsouth
Healthcare
2002
Adecco
Human Resource Solutions
2004
Homestore.com
Real Estate
2002
Panalpina
Logistics
2005
Kmart
Discount Retail
2002
Liberate Technologies Software
12
Principles-Based GAAP (IFRS)
Netherlands
Switzerland
Ashtead Group
2002
Merck
Pharmaceuticals
2002
Mirant
Electricity Production
2002
NextCard
Consumer Financial Services
2001
Niccor Energy
Gas & Power
2002
Peregrine Systems
Software
2002
PNC Financial
Financial Services
2002
Qwest
Telecommunications
2002
Refco
Investment Services
2005
Reliant Energy
Gas & Power
2002
Sunbeam
Electronics, Home Appliances
2001
Tribune Company
Media and Newspapers
2004
Teltran International
Telecommunications
2001
WorldCom
Telecommunications
2001
Xerox
Office Equipment
2002
NOVEMBER 2007
Italy
United Kingdom
Telecommunications
|
France
2002
Lucent Technologies
Tennessee CPA Journal
HIH Insurance
Insurance
Engineering
Pharmaceuticals
Retail
Construction Equipment Rental
2001
2001
2003
2004
2003