Accounting Scandals: Does Rules vs. Principles Matter

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Content: 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
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 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 and the SEC's Accounting and Auditing Enforcement Releases (AAERs). For each corporate scandal identified, information relating
10 Tennessee CPA Journal | NOVEMBER 2007
to the main business sector in which the
Technologies, Mirant, NextCard, Peregrine
company operated and the year in which Systems, Refco, Teltran International and
the scandal became public knowledge is
WorldCom. Global Crossing also went
bankrupt, but it was the deterioration of its
Figure 1: Countries Reporting Accounting During the Period 2001 - 2005
underlying business rather than financial misreporting that
Rules-Based GAAP
Principles-Based GAAP (or IFRS)
was the primary cause.8 The financial
United States
Australia, France, Ireland, Italy,
misreporting was
Netherlands, Switzerland, United Kingdom typically caused by
improper revenue
recognition and/or improper expense
SCANDALS DURING 2001-2005 Table 1 (see page 12) lists each of the corporate accounting scandals and whether they occurred under rules-based U.S. GAAP or the more principles-based IFRS. During the five-year period 2001 to 2005, accounting scandals at 38 companies became public knowledge under the U.S. rules-based GAAP system as compared to only 12 companies under the more principles-based IFRS system. Thus, during the period 2001 to 2005, more than three times as many accounting scandals were reported in the United States than in principles-based jurisdictions. This result holds, even if we consider the total number of publicly-listed corporations in these eight countries. There are approximately 6,811 companies publicly listed in the United States versus approximately 6,892 companies listed in the seven principlesbased countries. During the period 20012005, 38 out of approximately 6,811, or 0.56 percent, of listed companies reported instances of financial misreporting in the United States, while only 12 out of approximately 6,892, or 0.17 percent, of listed companies reported instances of financial misreporting in the seven principles-based countries. All other
The magnitude of the scandals at three companies (or 25 percent) using principles-based standards, namely, HIH Insurance, Parmalat and Cirio Finanziaria, was sufficient to trigger bankruptcy proceedings. The nature of the misreporting was rather dispersed, including improper revenue recognition, improper expense recognition, improper accounting in connection with business combinations and direct violations of accounting principles. Additionally, the role of American influence was evident in two of the 12 companies (Royal Ahold and Alstom). Not only did these two companies have U.S. stock exchange listings, but their accounting problems originated with their American subsidiaries.9 Thus, it appears that the magnitude of the misreporting triggered a relatively higher number of bankruptcy filings under U.S. GAAP as compared to IFRS. Prior research also suggests that lax enforcement of IFRS may result in limited compliance with IFRS, thereby limiting their effectiveness.10 One wonders whether the lower number of reported accounting scandals under the seven principlesbased (international) regimes is partially due to looser enforcement of accounting standards in countries outside the United States.
things being equal, this suggests that a higher incidence of corporate accounting
fraud occured inside the United States as
The results of the study show a
compared to outside the United States.
higher incidence of corporate accounting
The magnitude of the accounting
fraud occurs in rules-based United States
scandal was sufficient to trigger filings
as compared to the more principles-
for Chapter 11 bankruptcy at 12 of the 38 based countries. However, variation in
companies (or 31.6 percent) following U.S. enforcement levels and other cross-country
GAAP, namely, Adelphia,,
differences like legal environment and
Delphi, Enron,, Liberate
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. 2. The White House. Framework for advancing transatlantic economic integration. April 30, 2007. 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 [email protected] Aamer Sheikh, Ph.D., CPA, CBM is an assistant professor of accounting at Quinnipiac University. He can be reached at [email protected] 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
Main Business
United States
Cable & Telecom Services
Insurance & Financial Services 2004
AOL Time Warner Media
Retail Services
Bristol-Myers Squibb Pharmaceuticals
CMS Energy
Gas & Power
Computer Associates IT Management Software
Critical Path
Business Services
Electronics & Transportation
Duke Energy
Gas & Power
Oil & Gas
El Paso Corporation Gas & Power
Gas & Power
Energy & Petrochemical
Fannie Mae
Mortgage Financing
Freddie Mac
Mortgage Financing
Global Crossing
Technical services, Construction 2002
Real Estate
Discount Retail
Liberate Technologies Software
Lucent Technologies Telecommunications
electricity production
Consumer Financial Services
Niccor Energy
Gas & Power
Peregrine Systems Software
PNC Financial
Financial Services
Investment Services
Reliant Energy
Gas & Power
Electronics, Home Appliances
Tribune Company Media and Newspapers
Teltran International Telecommunications
office equipment
Principles-Based GAAP (IFRS)
Main Business
HIH Insurance Insurance
Vivendi Universal Media & Telecommunications
2002 2003
Ireland Elan
Italy Parmalat Cirio Finanziaria Skandia
food processing Food Processing Financial Services
2003 2002 2003
Royal Ahold
Royal Dutch Shell Energy & Petrochemical
2003 2004
Switzerland Adecco Panalpina
Human Resource Solutions Logistics
2004 2005
United Kingdom Ashtead Group
Construction Equipment Rental 2003
12 Tennessee CPA Journal | NOVEMBER 2007

File: accounting-scandals-does-rules-vs-principles-matter.pdf
Title: Accounting Scandals: Does "Rules vs. Principles" Matter?
Author: Alexis V. Nisbett and Aamer Sheikh, Ph.D., CPA , CBM
Subject: Fraud
Keywords: Accounting Scandals: Does "Rules vs. Principles" Matter?, Alexis V. Nisbett and Aamer Sheikh, Ph.D., CPA , CBM, Fraud
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