Effect of Principles-Based Versus Rules-Based Standards and Auditor Type on Financial Managers' Reporting Judgments

Abstract

Managers sometimes implement accounting standards (such as the lease standard) opportunistically to move debt off balance-sheet. Regulators are under pressure to adopt principles-based accounting standards to reduce such opportunism. However, there are lingering concerns about whether principles-based standards can be properly implemented and enforced. We report results of an experiment where highly experienced financial managers, with incentives to structure a transaction off balance sheet, take a reporting position on how a lease is to be disclosed. We manipulate the type of GAAP (principles-based, rules-based) and the type of auditor (client-oriented, principles-oriented, or rules-oriented). Our results show that when the auditor is client-oriented, the nature of GAAP does not matter, and that a move towards more principles-based standards is likely to result in improved financial reporting quality only when there is a corresponding shift in auditors' mindsets towards beings more principles-oriented.

Keywords: principles-based standards, rules-based standards, auditor type, off balance sheet debt, transaction structuring

JEL Classification: M41, M44, M49, G32, C91