How Does the Strength of the Financial Regulatory Regime Influence Auditors’ Judgments to Constrain Aggressive Reporting in a Principles-Based Versus Rules-Based Accounting Environment?

41 Pages Posted: 25 Apr 2011 Last revised: 22 Mar 2013

Jeffrey R. Cohen

Boston College - Department of Accounting

Ganesh Krishnamoorthy

Northeastern University

Marietta Peytcheva

Lehigh University

Arnold Wright

Northeastern University - Accounting Group

Date Written: March 20, 2013

Abstract

With the movement towards adoption of International Financial Reporting Standards (IFRS) worldwide, a question arises as to whether the adoption of a principles-based approach such as IFRS will ultimately result in higher quality financial reporting. This issue is particularly relevant because, even though for now the SEC is not adopting IFRS, the securities markets and the SEC still need to ponder the implications of a decision that may lead to the ultimate adoption of, or at least some degree of convergence with, IFRS in the U.S. To examine this issue, we employ an experiment with 97 experienced auditors as participants. Using a case setting involving the classification of a lease (operating versus capital), we manipulate the accounting standard type as rules-based or principles-based, and the regulatory regime as stronger or weaker. The lease setting is one where there are indications of management’s incentives to leave the debt off of the balance sheet and hence engage in aggressive reporting. We find, as expected, that auditors are more likely to constrain aggressive reporting under principles-based accounting standards than under rules-based standards, under both stronger and weaker regulatory regimes. Importantly, from a public policy perspective, the results indicate that auditors’ judgments under principles-based standards, regardless of the strength of the financial regulatory regime, lead to more conservative reporting when compared to rules-based standards coupled with a stronger financial regulatory regime, which is the way the U.S. environment is often characterized.

Keywords: Financial regulatory regime, Principles-based standards, Rules-based standards, Audit judgments, Public Policy

JEL Classification: M42

Suggested Citation

Cohen, Jeffrey R. and Krishnamoorthy, Ganesh and Peytcheva, Marietta and Wright, Arnold, How Does the Strength of the Financial Regulatory Regime Influence Auditors’ Judgments to Constrain Aggressive Reporting in a Principles-Based Versus Rules-Based Accounting Environment? (March 20, 2013). Accounting Horizons, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1817684 or http://dx.doi.org/10.2139/ssrn.1817684

Jeffrey R. Cohen (Contact Author)

Boston College - Department of Accounting ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States
617-552-3165 (Phone)
617-552-2097 (Fax)

Ganesh Krishnamoorthy

Northeastern University ( email )

360 Huntington Ave.
Boston, MA 02115
617-373-4651 (Phone)
617-373-8814 (Fax)

Marietta Peytcheva

Lehigh University ( email )

621 Taylor Street
Bethlehem, PA 18015
United States
610 758 2818 (Phone)
610 758 5992 (Fax)

Arnold Wright

Northeastern University - Accounting Group ( email )

406 Hayden Hall
United States

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