A Guide for More Accurate, Transparent Financial Reporting

The accounting profession has been gripped for decades by the debate between advocates of a regime based on rules and those who prefer principles.

Many countries—including Australia, France, Ireland, Italy, the Netherlands, Switzerland, and the United Kingdom—lean toward principles-based accounting, which requires auditors to exercise judgment when making reports.

However, the United States relies on a rules-based standard, as critics of the principles-based approach say it invites accounting abuses. And in September 2002, in the wake of major accounting scandals and resulting regulation, the Financial Accounting Standards Board published a discussion paper seeking views on whether a US standard setting should move toward a more principles-based approach. Based on feedback it received, the agency now argues that focusing more clearly on principles would improve transparency in financial accounting and reporting.

But according to Chicago Booth’s Pingyang Gao and Haresh Sapra and New York University’s Hao Xue, the best system would combine the two approaches.

To develop an optimal accounting standard, the researchers constructed a model with four parties/actors: a business, an auditor, a standard setter, and investors.

The model incorporates two contentious issues that have plagued the accounting profession: managerial interference and illegal side payments. For a given economic transaction, a company’s management can improve the accuracy of an audit by “managing” evidence, or disclosing better-quality evidence to the auditor. Management can also improve its chances of clearing an audit by providing a side payment to the auditor—illegal in the real world but an important variable for modeling purposes.

Gao, Sapra, and Xue contend that the standard-setting process should include both rules and principles, adjusted in proportion to the quality of evidence provided.

They say the optimal standard should rely more on principles when the auditor’s independence is harder to compromise, as well as when it’s costly for managers to tamper with evidence they give to the auditor. Tampering can be costly to a manager when investors, concerned that tampering may have occurred, may choose not to invest. When evidence meets a threshold of being sufficient, the optimal standard is principles based.

When evidence about company financial statements is weak, the findings indicate, auditors should adopt rules-based standards to avoid manipulation by management. And in each case, standard setters should assess the strength of the evidence and see if his or her professional judgment produces a decision that aligns with a rules-based approach.

The research suggests that rather than choosing between rules and principles, combining the approaches could produce an accounting standard that provides greater quality and transparency in financial reporting.