High-profile corporate accounting scandals, from Enron to Worldcom, threaten both the security of the financial system and individuals’ confidence in it. One essential change in United States accounting standards may help reduce the likelihood of these types of incidents reoccurring, according to the University of Delaware’s George Tsakumis.
Earlier this year, Tsakumis, who is an associate professor of accounting and Iannaccone Faculty Fellow at UD’s Alfred Lerner College of Business and Economics, was a co-recipient of the American Accounting Association’s 2019 Notable Contribution to the Auditing Literature Award. This award recognizes a published work of exceptional merit that makes a significant contribution to auditing or assurance research, education or practice. Tsakumis and his coauthors received the award for a 2011 paper published in The Accounting Review, one of accounting academia’s top journals.
Since its publication, researchers have cited the paper, “Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions,” more than 250 times. Reports from several high-profile regulatory and practice organizations have also cited the research. Further, doctoral research seminars at some of the world’s finest institutions have used the paper for instructional purposes.
The idea behind the influential work is that a shift from “rules-based” to “principles-based” accounting standards may encourage less aggressive financial reporting (such as overstating financial performance) on the part of CFOs. Today, the United States uses the largely rules-based Generally Accepted Accounting Principles (GAAP), while most countries use the more principles-based International Financial Reporting Standards (IFRS).
The United States may want to consider switching to a system like the IFRS, the research suggests, because doing so can result in a domino effect that prevents firms from making poor quality decisions and shirking their public responsibility. CFOs are critical in this process, Tsakumis said, because they serve as “the organization’s financial ‘gatekeeper.’”
“CFOs have become increasingly involved in critical activities across the organization,” he said. “If a CFO is tempted to engage in aggressive financial reporting either on behalf of the firm or themselves, this could send a message to others in the firm that ‘this is how we do things.’ With their influence over firms’ resources, CFOs’ unethical behavior can cause serious damage to organizations and even undermine the credibility of our financial system.”
To help combat this problem, Tsakumis explained, principles-based standards “provide companies with limited interpretive and implementation guidance. The theoretical reason behind this standard design is that less guidance forces companies to take a ‘step back’ before applying an accounting standard, thereby increasing the need for companies’ decision makers to apply professional judgment consistent with the intent of the standards, resulting in more meaningful and informative financial statements.”
Conversely, “Rules-based standards invite focus on meeting the letter of the rule (as opposed to its spirit) and lead to a ‘show me where the rule says I can’t do it’ attitude, which often leads to dysfunctional financial reporting outcomes,” he said. “For example, if a corporate executive desires to disguise the true nature of a transaction, critics argue that rules-based standards allow the individual to structure the transaction to ‘get around’ the rule so that it still technically meets the requirements. This is one of the reasons why for the last 10 plus years, GAAP and IFRS have begun a formal ‘convergence’ process, which is resulting in U.S. GAAP becoming more like its more principles-based counterpart, IFRS, over time.”
“We find that the less precise the standard, the more concerned CFOs are about possible costs imposed through regulation and litigation,” he said. “In turn, this results in an increased desire to reflect the true underlying economic substance of an accounting transaction and less aggressive financial reporting. We also find that switching to a more principles-based approach may have a greater dampening effect on CFOs aggressive reporting than does strengthening the audit committee, which is a key corporate governance mechanism.”
Tsakumis added that he and his coauthors are proud that their paper has made such an impact on accounting research, practice and teaching: “We were thrilled to be chosen for this prestigious award. It’s an honor to know that our fellow accounting academics believed that our paper made a significant enough contribution to merit selection for the 2019 Notable Contribution to Auditing Literature Award.”