By Alexis V. Nisbett and Aamer Sheikh, Ph.D., CPA , CBM
Accounting Scandals: Does Rules vs. Principles Matter? 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 nancial 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 exible 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 rm PricewaterhouseCoopers in The Wall Street Journal where the rm claimed that: Rules-based systems encourage creativity (and not the good kind) in nancial 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 cant 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 nancial statements that their IPAs [Independent Public Accountants] would have to or could attest did fairly present the nancial conditions of the corporation in accordance with generally accepted accounting principles. In particular, with respect to Enron, the audit rm Arthur Andersen was charged with designing nancial instruments that met the technical requirements of GAAP while violating the intent. Public disclosure of Enrons 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 rules- based. In practice, one may argue that the detailed implementation guidance fosters an alleged current check- the-box or compliance mentality to nancial 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 cross- checked this list of 30 countries to the IAS Plus Web site, maintained by Deloitte, which provides comprehensive information about international nancial reporting. 7 More specically, 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 classied 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 classications of the remaining eight countries. In order to ensure that only scandals that were caused by an accounting irregularity (like overstating revenue by recording ctitious 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 Schools Securities Class Action Clearinghouse (available at securities.stanford.edu) and the SECs Accounting and Auditing Enforcement Releases (AAERs). For each corporate scandal identied, information relating Tennessee CPA Journal | NOVEMBER 2007 11 to the main business sector in which the company operated and the year in which the scandal became public knowledge is obtained. INCIDENCE OF ACCOUNTING 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 ve-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 principles- based countries. During the period 2001- 2005, 38 out of approximately 6,811, or 0.56 percent, of listed companies reported instances of nancial misreporting in the United States, while only 12 out of approximately 6,892, or 0.17 percent, of listed companies reported instances of nancial misreporting in the seven 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 sufcient to trigger lings 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 Technologies, Mirant, NextCard, Peregrine Systems, Refco, Teltran International and WorldCom. Global Crossing also went bankrupt, but it was the deterioration of its underlying business rather than nancial misreporting that was the primary cause. 8 The nancial misreporting was typically caused by improper revenue recognition and/or improper expense recognition. The magnitude of the scandals at three companies (or 25 percent) using principles-based standards, namely, HIH Insurance, Parmalat and Cirio Finanziaria, was sufcient 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 inuence 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 lings 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 principles- based (international) regimes is partially due to looser enforcement of accounting standards in countries outside the United States. 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 principles- based 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 nancial 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 principles- based accounting standards would lead to a lower incidence of nancial 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. Whats 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: Its not new, its not the rule, its 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. Figure 1: Countries Reporting Accounting During the Period 2001 - 2005 Rules-Based GAAP Principles-Based GAAP (or IFRS) United States Australia, France, Ireland, Italy, Netherlands, Switzerland, United Kingdom See table on page 12 12 Tennessee CPA Journal | NOVEMBER 2007 Rules-Based GAAP Company Main Business Year United States Adelphia Cable & Telecom Services 2002 AIG Insurance & Financial Services 2004 AOL Time Warner Media 2002 Ashford.com Retail Services 2001 Bristol-Myers Squibb Pharmaceuticals 2002 Broadcom Semiconductors 2001 CMS Energy Gas & Power 2002 Computer Associates IT Management Software 2002 Critical Path Business Services 2001 Delphi Electronics & Transportation 2004 Duke Energy Gas & Power 2002 Dynegy Oil & Gas 2002 El Paso Corporation Gas & Power 2002 Enron Gas & Power 2001 Exxon Energy & Petrochemical 2001 Fannie Mae Mortgage Financing 2004 Freddie Mac Mortgage Financing 2003 Global Crossing Telecommunications 2002 Halliburton Technical services, Construction 2002 Healthsouth Healthcare 2002 Homestore.com Real Estate 2002 Kmart Discount Retail 2002 Liberate Technologies Software 2002 Lucent Technologies Telecommunications 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 Ofce Equipment 2002 Principles-Based GAAP (IFRS) Company Main Business Year Australia HIH Insurance Insurance 2001 France Vivendi Universal Media & Telecommunications 2002 Alstom Engineering 2003 Ireland Elan Pharmaceuticals 2001 Italy Parmalat Food Processing 2003 Cirio Finanziaria Food Processing 2002 Skandia Financial Services 2003 Netherlands Royal Ahold Retail 2003 Royal Dutch Shell Energy & Petrochemical 2004 Switzerland Adecco Human Resource Solutions 2004 Panalpina Logistics 2005 United Kingdom Ashtead Group Construction Equipment Rental 2003 Table 1: Rules-Based vs. Principles-Based Accounting Standards & the Incidence of Corporate Financial Misreporting During the Period 2001 - 2005
A Perspective On The SEC's Proposal To Accept Financial Statements Prepared in Accordance With International Financial Reporting Standards (IFRS) Without Reconciliation