Principles-Based Versus Rules-Based Accounting Standards: the Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decision

PRINCIPLES-BASED VERSUS RULES-BASED ACCOUNTING STANDARDS: THE INFLUENCE OF STANDARD PRECISION AND AUDIT COMMITTEE STRENGTH ON FINANCIAL REPORTING DECISION ————————————————- BUS 421 ACCOUNTING THEORY E100 ————————————————- Presented To: Karel Hrazdil ————————————————- Presented by: Shirley Mi Chen (301069071) ABSTRACT

Agoglia, Doupnik, and Tsakumis (2011) examined two hypothesis in their paper and concluded that preparers of financial statement are more likely to report aggressively under a more precise accounting standard; and the role of audit committee is greatly weakened in a less precise standard setting. With the principles-based accounting standards, prepares fear uncertainties brought by the flexibility of judgment and are more likely to report using a method that best reflect the value of the firm.

This article and its findings also relates to the positive accounting theory seeking to explain and predict management’s choice of decision in accounting reporting. PAPER Accounting scandals back in the early 2000, including that of Enron and WorldCom, led to the passing of the Sarbanes-Oxley Act (SOX). SOX aims to reduce corporate governance concern and ultimately seek to increase the credibility of the financial reporting.

Agoglia, Doupnik, and Tsakumis (2011) looked at two aspects related to the strength of the financial reporting: the influence of standard precision and the role of audit committee. This article had and referred to with particularly focus on the circumstance in US with regards to their rules-based approach of accounting. The more precision based accounting standards in US is suppose to dampen the executives’ ability to manipulate financial results as well as increase comparability across all firms.

However, all the accounting scandals brought to the attention of the public has began to question whether the rules-based standards are serving their purpose better than the other option: principle-based. Originally, the view was principle-based accounting standards offers more room for flexibility and interpretation in the view of the executives and therefore more prone to manipulation because it allows for differences in judgment. This also implies of reduced comparability across firms because of the variations permitted. However, research from the article suggests otherwise.

Results from the experiment showed that under the precise standard, or the rules-based standards, preparers are more likely to make aggressive financial reporting decisions (Agoglia et al. 2011, p. 10). Thus, on the opposite side, principle-based standards result in less aggressive reporting style (Agoglia et al. 2011, p. 10). The argument for that is because less precise standards allows for more room for judgment, the preparers are more concerned “about second-guessing and possible costs imposed through regulation and litigation” (Agoglia et al. 2011, p. 10).

This means under less precise standards, the preparers will have to worry about the “uncertainty surrounding the risk of being perceived to be out of compliance” and therefore are ultimately more likely to select the method that best reflect the true economic value to avoid being seen as out of compliance(Agoglia et al. 2011,p. 5). As for comparability, Agoglia et al. found little variation under less precise standards, implying preparers are likely conform to the same set of methods under their judgment; consequently, implying good comparability across different firms (2011, p. 18).

Agoglia, Doupnik, and Tsakumis also examined the function of audit committee in a more principle-based accounting environment and the weight of their roles. Findings conclude that a strong audit committee is needed in terms of a more precise standard application to closely monitor the preparer for aggressive reporting (Agoglia et al. 2011). With a less precise standard setting, strength or presence of audit committee has no effect to aggressive reporting (Agoglia et al. 2011). The above two results illustrate some of the advantages principle-based standard has over rules-based.

Under the less principle-based standards, the management can exert more flexibility in better reflecting the true economic value of their firm. Agoglia et al. also observed how under a less precise standards are associated with less aggressive accounting reporting, questioning whether US should shift its policy to a more principle-based standards. The finding on the audit committee gave insight to some of the other advantages principle-based standards offer. There’s a lesser need for strong audit committee and their strict monitoring over the management.

All of these entails a reduced agency cost and a better financial statement that better reflect the firm’s true economic value. However, one major drawback of the research conducted in the article is the authors based their analysis specifically on the participating CFO’s decision on leases. This is just a particular balance sheet/income statement item being looked at. Realistically, there are many decision being made during the preparation of the financial statement. Many of them will be different in nature with different functions on the statements and the purpose they serve compared to each other.

Also, in the research, the preparers were all given one clear incentive when making the decision. In reality, different corporate executives will face different incentives when making choices preparing the financial statements. This will potentially impact the consensus in decision making observed in the article’s experiment; and thus the comparability questioned. Agoglia et al. looked at the standard settings in the US and observing management’s reaction to different types of accounting standards. The article’s finding can be directly related to the positive accounting theory (PAT).

The positive accounting theory seeks to explain and predict management’s choice in accounting policy and how they respond to different accounting standards. In the opportunistic perspective, the flexibility in accounting policies will give the management team the option to select the one policy best to their own advantage (William R. Scott, 2012, p. 319). While on the other hand, efficient contracting perspective, states flexibility in accounting standards will better enable the firm to “respond efficiently to unforeseen events “, ultimately better reflect the economic value of the firm (William R.

Scott, 2012, p. 319). The findings presented by Agoglia et al. (2011) relates to both of these views. But it could be argues that both the opportunistic and the efficient contracting theory applies in this case. Because of the uncertainty offered by less precise standards, management try to apply a policy that best reflect the true value of the firm to avoid being perceived being out of compliance. Thus it is both used to management’s interest not to incur cost due to incompliance and better prepare statements to reflect value of the firm utilizing flexibility offered by the less precise standards.

Overall, Agoglia et al. (2011) seeks to predict the management’s actions in two different types of accounting standards settings: principle-based and rules-based. Findings conclude that principle-based accounting standards are more favorable with regards to decreasing aggressive accounting reporting styles (Agoglia et al. 2011). The preparers are also more diligent in their approach to better reflect the true economic value of the firm and able to do so even without the strict monitoring of a strong audit committee presence (Agoglia et al. 2011,p. 5).

As the PAT suggests, introduction to a more precise standard and limits the existing accounting policy choice will be met by strong management reactions (William R. Scott, 2012, p. 318). Thus, adoptions to a less precise standard will also be more easily accepted to the management body compared to the other way around (William R. Scott, 2012, p. 318). This implies if there were to be a shift from more rules-based accounting standard towards a more principle-based standard, it will not be met with strong management reactions and are likely to more acceptable to the management body.

This will be an interesting finding to the US policymakers in their reform for better accounting standards. REFERENCE Agoglia, C. P. , Doupnik, T. S. , ; Tsakumis, G. T. (2011). Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions. The Accounting Review, 86(3), 747-767 Scott, W. R. , (2012). Financial Accounting Theory (6th ed. ). Toronto: Pearson Prentice Hall.

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