Introduction During the early 2000s, a number of major scandals involving corporate giants such as Enron and WorldCom ignited a fierce debate about whether the U.S. should abandon the allegedly rules-based accounting system and adopt a principles-based system. Proponents of principles-based accounting blame the rules-based accounting system for these major accounting scandals. They believe that the rules-based system encourages the use of financial structuring to achieve desired accounting results, which will undermine the quality of financial reporting. Rules-based accounting puts the focus on compliance, rather than communication. Supporters of rules-based accounting argue that principles-based accounting relies heavily on judgment, which will reduce the consistency and comparability of financial information. As a reaction to the accounting scandals, the Congress enacted the Sarbanes-Oxley Act in 2002, of which former President George W. Bush regarded it as “the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” Section 108(d) of the Sarbanes-Oxley Act required the Securities and Exchange Commission (SEC) to conduct a study on the adoption by the United States financial reporting system of a principles-based accounting system. In 2002, the Standards Board (FASB) issued a proposal, Principles-Based Approach to U.S. Standard Setting , in response to concerns about the quality and transparency of financial reporting in the U.S. In 2003, the SEC staff submitted its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (the SEC Study) to the Congress, making several recommendations to the FASB. Both the FASB and SEC believed that moving towards more objectives-oriented or principles-based standards was the future direction of accounting standard setting. The rules-based and principles-based accounting systems have their own merits and drawbacks - neither one is better than the other in all aspects. In recent years, the FASB has issued several standards that are more principles-based. The purpose of this paper is to examine which accounting system is more suitable to the U.S. The discussion is limited to the U.S. only because situations in other countries may be different from those in the U.S. Since there are different views on the meaning of the term “principles-based”, this paper will begin by discussing the definitions of “principles-based accounting” and “rules-based

1 accounting”, as well as their differences. Then I will discuss the evolution of U.S. Generally Accepted Accounting Principles (GAAP), examining the forces that drive U.S. GAAP towards more rules-based. The paper will compare the merits and drawbacks of the two accounting systems from the perspective of different stakeholders. I will provide arguments for why a principles-based accounting system is more suitable to the U.S. Finally, I will discuss the limitation of principles-based accounting and its remedies.

Definitions of Rules-Based Accounting and Principles-Based Accounting Accounting standards under a rules-based system have three major characteristics. First, they provide a lot of exceptions that create situations in which the principles in the standards do not apply. There are three different types of exceptions – scope exceptions, application exceptions, and transition exceptions (FASB, 2002, 3). Scope exceptions allow the use of other existing accounting pronouncements to account for transactions and events that would otherwise be accounted for under the standards. Application exceptions allow the deviation from the principle of the standards and the use of alternative accounting treatments to account for certain transactions. This type of exception is provided to achieve a desired accounting result such as reducing the volatility of reporting earnings caused by the application of the principles in the standards. Transition exceptions are provided to alleviate the effects of transitioning to new accounting standards. This type of exception allows the use of the old rules to account for transactions occurred before the effective date of the new standards. Another characteristic of rules-based accounting standards is that they contain many bright-line tests. The bright-line tests are often provided to help determine whether a transaction or event falls under the exception rules. Rules-based standards are also characterized as containing a lot of detailed interpretive and implementation guidance. This guidance is often necessary because it describes the application of the exceptions. There are different views on the definition of principles-based accounting. A common view is that accounting standards under a principles-based accounting system are generally developed from a conceptual framework. They provide only general guidance on how to account for particular transactions. Management is required to exercise judgment and expertise when applying the accounting principles (Tribunella 2009, 33).

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Some people view principles-based accounting the same as a principles-only approach. Principles-only accounting standards are defined as high-level standards with little or no operational guidance. Preparers of financial statements and auditors have to exercise judgment in accounting for transactions and events, but the standards do not provide a sufficient structure to frame the judgment (SEC, 2003). Therefore, similar transactions are accounted for differently across firms. People who hold such a view often oppose the adoption of principles-based accounting because the heavy reliance on judgment decreases comparability among reporting entities. In the SEC Study, the SEC staff provides a different definition for principles-based accounting, in which they refer it as an objective-oriented approach. Accounting standards under such an approach should have the following five characteristics: • Be based on an improved and consistently applied conceptual framework; • Clearly state the objective of the accounting standard; • Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis; • Minimize exceptions from the standard; • Avoid use of percentage tests (“bright-lines”) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard. (SEC, 2003) The objective-oriented approach seems to be an ideal approach of accounting standard setting, but in practice such an approach may be difficult to implement. “Sufficient detail” or “optimal level of detail” is a major characteristic of the objective-oriented approach; however, the words “sufficient” and “optimal” are ambiguous since the SEC does not specify how much detail constitutes “sufficient” and “optimal.” As illustrated in a later section, preparers and auditors always request more detailed guidance because they feel more comfortable with a certain and clear answer. The FASB must deal with the pressure from these constituents. In some cases, the FASB may have to concede and end up providing more than their interpretation of the “sufficient” amount of guidance. Lease accounting under U.S. GAAP and International Financial Reporting Standards (IFRS) best illustrates the differences between rules-based and principles-based accounting. U.S.

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GAAP is usually considered rules-based, while IFRS is considered principles-based. Under U.S. GAAP, a lease is considered a capital lease if it meets any of the following four criteria: 1. The lease transfers ownership of the property to the lessee by the end of the lease term; 2. The lease contains a bargain purchase option; 3. The lease term is equal to 75 percent or more of the estimated economic life of the property; or 4. The present value of the minimum lease payments is equal to or greater than 90 percent of the of the property. (Accounting Standards Codification Par. 840-10-25-1) These criteria are examples of bright-line tests, in which the third and fourth criteria contain strict percentage thresholds. In contrast, under IFRS, a lease is classified as a lease (equivalent to a capital lease under U.S. GAAP) if it transfers substantially all the risks and rewards incidental to ownership of an (IASB, IAS, par.8). The IASB also provides several examples and indicators of situations that individually or in combination may lead to a lease being classified as a finance lease (IASB, IAS, pars. 10-11). These examples and indicators are similar to the four criteria of classifying a lease as a capital lease under U.S. GAAP. However, the IASB does not provide any specified percentage in the examples related to the economic life of the asset and minimum lease payments. Instead it uses terms such as “substantially all” and “major part” which require the to exercise judgment when interpreting these terms. In addition, before the codification of U.S. GAAP, the accounting literature for leases was composed of 16 FASB Statements and Interpretations, nine Technical Bulletins, and more than 30 EITF Issues (SEC, 2003). This large volume of interpretive and implementation guidance is one of the characteristics of rules-based accounting standards. Although U.S. GAAP is widely viewed as rules-based, it is actually a combination of rules-based, principles-based, and principles-only standards. Standards related to accounting for leases, accounting for derivatives and hedging activities, stock-based compensation arrangements, and derecognition of financial and liabilities are considered more rules- based. These standards provide a lot of exceptions, bright-line tests, and detailed implementation guidance. According to the SEC, examples of principles-based accounting standards include standards dealing with business combinations and and other intangible assets (SEC,

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2003). These standards contain few scope exceptions and bright-line tests. The SEC considers of depreciable assets as an example of principles-only standards (SEC, 2003). The FASB only establishes the basic principle but may not provide sufficient guidance for implementation. Classifying a particular accounting standard as either strictly rules-based or principles- based is inappropriate because the accounting standard often has characteristics of both rules- based and principles-based accounting systems. According to Bennett, Bradbury, and Prangnell, the distinction between rules-based and principles-based accounting standards is not well defined and is subject to different interpretations (Bennett et al. 2006, 191). They conclude that the rules-based versus principles-based distinction is not meaningful unless it is in relative terms. Classifying accounting standards along a continuum of “rules-based” (more rules-based characteristics) and “principles-only” (no rules-based characteristics) would be more appropriate. Principles-based accounting standards fall between the two extremes. Since U.S. GAAP contains more bright-lines and exceptions, it is considered to be more rules-based. IFRS is considered more principles-based because it has fewer rules-based characteristics.

Evolution of U.S. GAAP Regulated U.S. GAAP has its history dated back to 1939, when the American Institute of Certified Public Accountants (AICPA) appointed the Committee on Accounting Procedure (CAP) to set accounting standards. During the years 1939 to 1959, the CAP issued 51 Bulletins (ARB) which deal with a variety of accounting problems. Due to the failure of the CAP to provide a structured body of accounting principles, the AICPA created the Accounting Principles Board (APB) in 1959. The APB issued 31 APB Opinions during the years 1959 to 1973. It was replaced by the FASB in 1973, which was designated by the SEC as the organization in the private sector for establishing standards of financial accounting. Since then, the FASB has issued many Statements of Financial Accounting Standards (SFAS), FASB Interpretations (FIN), FASB Technical Bulletins (FTB), FASB Staff Positions (FSP), FASB Implementation Guides (Q & A), and Emerging Issues Task Force (EITF) Abstracts. In 2009, the FASB declared the Accounting Standards Codification (Codification) as the single source of authoritative nongovernmental U.S. GAAP. The Codification is composed of accounting literatures issued by various standards setters, including the CAP, the APB, the FASB, and the

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AICPA. The Codification also includes some relevant portions of authoritative content issued by the SEC. There are several forces that push U.S. GAAP to become more rules-based, including the legal environment, economic environment, and regulatory environment. In the litigious environment in the United States, management and auditors have a strong incentive to ask the FASB to provide as much guidance as possible. Management and auditors want to avoid the risk of lawsuits based on wrong application of accounting standards. They want the FASB to provide a clear answer for every perceivable accounting issue. They believe that if they are able to demonstrate compliance with the accounting standards, then they can avoid the risk of litigation and criticism. Thus, management and auditors always demand the FASB to provide authoritative guidance on the interpretation of accounting principles, so that they can apply the accounting principles correctly. The increasing complexity of the economic environment is a strong force that drives U.S. GAAP to become more rules-based. This increasing complexity is caused by the increasing sophistication of the capital market, as well as the creativity of management, investment bankers, and other financial advisors. Many companies use complex financial instruments such as derivatives to hedge their risks. Some companies also use complex transactions to achieve a desired accounting result. Accounting for leases and accounting for derivatives and hedging activities under U.S. GAAP are often considered to be overly rules-based because the FASB issued a lot of detailed interpretive and implementation guidance for accounting for these complex and sophisticated transactions. More complex and sophisticated business structures also lead to the increase in complexity of accounting standards. Before 2003, accounting literature related to special-purpose entities (SPEs) was inadequate and incomplete. Companies such as Enron took advantage of the lack of standards and used SPEs that were not consolidated to hide their debts and losses. Enron, by 2001, had used hundreds of SPEs to avoid reporting its debts and losses by hiding them in these SPEs. After the Enron scandal, the FASB issued the FASB Interpretation No. 46 in 2003 to close this loophole. The circumvention of the rules by complex organization structures and transactions prompted the FASB to issue more standards and guidance to close the loopholes, making U.S. GAAP more rules-based. The objective of the standard setters and regulators to reduce the opportunities of managers to use judgments to manage earnings is another force that drives U.S. GAAP towards

6 more rules-based (Benston et al. 2006, 168). The mission of the FASB is to develop high-quality accounting standards that serve the public interest by providing information that is useful to present and potential investors and creditors and other users in making investment, credit, and other similar decisions (FASB, 2002, 1). The mission of the SEC is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. Both the FASB and the SEC want to ensure that the financial information provided to the external users are reliable. They want to avoid crisis, so they issue more and more rules in an attempt to constrain behavior. These rules are intended to cover almost every conceivable situation, so that similar transactions can be accounted for consistently and management cannot manage earnings by using judgment.

Comparison of the Merits and Drawbacks of Using Principles-Based and Rules-Based Accounting from the Perspective of Different Stakeholders

1. Companies Under a rules-based accounting system, the risk of being sued for misstatement in financial reporting is smaller for companies. According to a recent study, rules-based accounting standards reduce the risk of litigation in two ways (Donelson et al. 2009, 29). First, rules-based accounting standards usually contain large amounts of detailed and complex implementation guidance. Courts presume that misstatements are error when convincing evidence of scienter (i.e., intent) is absent, given the complexity of U.S. GAAP. Violating a more complex accounting standard tends to be viewed as an innocent mistake. Second, if a company complies with the accounting standards, this compliance provides a shield for the company to avoid legal challenges to its accounting method. However, if compelling evidence of the company’s intent to violate the accounting standards is present, the rules-based standards provide a strong basis for conviction. From the standpoint of some companies, rules-based accounting is beneficial because they can avoid certain accounting treatments to achieve a desirable accounting result by structuring transactions. When companies make a decision on whether to engage in a certain transaction, they tend to consider carefully the accounting treatment of the transaction and the impact on financial result. Some companies structure their transactions to meet the market expectation of earnings and to avoid violating debt covenants. For example, a company may not

7 want to incur additional liability on its because the additional liability will make the debt- ratio exceed the designated ratio stated in the debt covenant. As illustrated before, a lease is classified as a capital lease if it meets any of the four criteria prescribed in the standard. If a lease is classified as a capital lease, the company is required to record the assets and the related lease liability on the balance sheet. To avoid recording the assets and liability on the balance sheet, companies may want to construct the lease agreement as an operating lease, in such a way that it fails to meet any of the four criteria. In testimony before the U.S. House of Representatives on February 14, 2002, Robert K. Herdman, Chief of the SEC, said that rules-based accounting standards provided extremely detailed rules that attempted to contemplate virtually every application of the standards, which encouraged a check-the-box mentality to financial reporting that eliminated judgments from the application of the reporting (Herdman, 2002). This may be good for the companies because they can be reasonably certain that a transaction or an event is accounted for correctly if they comply with the rules. However, in the SEC Study, the SEC staffs argue that judgment is not eliminated at all under a rules-based accounting system (SEC 2003). The judgment just shifts to determining whether a transaction falls under certain exception rules and which rules are applicable. The SEC staffs also say that no standard setter can ever sufficiently identify the many different business situations to which accounting standards must be applied. Here I agree with the SEC staffs because the economic environment is dynamic – it is changing rapidly. It is impossible for any standard setter to set rules that can cover all business situations. The change in economic environment is always faster than the change in accounting rules because the standard setting process requires extensive discussion. In some situations management may still need to exercise judgment because specific accounting rules have not been issued yet for the new form of transaction. Under a principles-based accounting system, preparers of financial statements have to exercise a great deal of judgment based on substance as opposed to a readymade solution for a particular issue prescribed in a rules-based accounting system (Kumar, 2010). Unlike rules-based accounting standards, principles-based standards do not have much interpretive and implementation guidance and they contain only a few bright-line tests. As illustrated previously, the IASB uses terms such as “substantially all” and “major part” in the standards for lease accounting, in contrast to the strict percentage tests provided by the FASB. Management has to

8 exercise judgment to determine what constitutes “substantially all” and “major part”. Different people may interpret the terms differently. Therefore, similar leases may be accounted for differently across firms.

2. Auditors Rules-based accounting standards provide auditors with a sense of security. Auditors feel more comfortable if what their clients do is in compliance with the accounting standards. The risk of litigation will be smaller for the auditors under a rules-based accounting system. The detailed implementation guidance provides auditors with a basis to conclude that their clients have accounted for all transactions and events correctly. However, rules-based accounting has a significant drawback for the auditors. Under rules-based accounting, auditors will find it difficult to argue with clients about certain treatment of a transaction if it is within the rules. Sometimes the clients may account for a transaction or event in a way that may not be morally and ethically acceptable, but in compliance with GAAP. The auditors may have difficulty in convincing their clients that the treatment for that transaction is inappropriate because the clients can respond by asking “show me where the rules say I can’t do that.” In research conducted by Mark W. Nelson, he argued that a precise standard enhanced the negotiating position of either the auditor or client, but whose position was strengthened depended on whether the transaction was structured (Nelson 2003, 97). When clients do not have any opportunities for transaction structuring or they are unaware of precise rules, precise standards tend to help auditors discourage aggressive reporting (Nelson 2003, 100). A survey reports that unstructured attempts to manage earnings under precise standards are usually unsuccessful and auditors are very likely to adjust the attempts of the management (Nelson et al. 2002, 194). This may be the case because the auditors know more about precise accounting rules than do their clients, so they are better able to identify the specific rules and precedents that prohibit the accounting treatment preferred by their clients (Nelson 2003, 97). Under principles-based accounting, the accounting standards will be less detailed and complex because they contain few exceptions, bright-line tests, and implementation guidance. Auditors need not spend as much time and effort on understanding and applying a detailed standard as in the case of rules-based accounting. In addition, it will be easier for auditors to

9 discuss how to apply a principles-based accounting standard to clients who do not have the accounting resources to learn all of the nuances of a detailed rule (Heffes 2004, 19). The problems of transaction structuring to achieve a desirable accounting result will be lessened under principles-based accounting because the standard is not precise enough to insure auditor’s approval of the structured transaction. However, the aforementioned survey reports that when standards are imprecise, auditors tend to waive adjustment of the transaction when management engages in unstructured aggressive reporting (Nelson et al. 2002, 97). Auditors often justify waiving these adjustment because the transaction is subjective and they cannot prove the position of the client is incorrect.

3. Financial Analysts Increasing complexity of business transactions makes the rules-based accounting standards more complicated. Financial analysts have to spend a long time to study the financial statements and the accompanying notes in order to analyze a company. Even though financial analysts tend to possess a higher level of accounting knowledge than retail investors, they may still have difficulty in understanding the complex accounting rules and their implication on the performance of the companies. The cost of performing financial analysis will be higher under rules-based accounting. Under a principles-based accounting system, financial analysts can spend less time on performing financial analysis for two reasons. First, the accounting standards are relatively easier to understand because of fewer inconsistencies caused by exception rules. Second, since the accounting standards emphasize the economic substance of a transaction, rather than its form, management is unlikely to structure transactions. Transactions will not be as complex as in the case of a rules-based accounting system. In addition, the cost of performing financial analysis will be lower.

4. The SEC The mission of the SEC is to protect the investors and maintain the integrity of the capital market. Investors need reliable financial information to make good investment decisions. However, practices by some companies hurt the quality of financial information. Government regulators want to avoid crisis, so they issue a lot of rules to constrain

10 the aggressive behavior in financial reporting. Rules-based accounting reduces the opportunities for earnings management by eliminating discretion. Management cannot claim that the accounting treatment for a particular transaction is correct based on their judgment while the accounting treatment is actually inappropriate. However, rules-based accounting increases the opportunities for earnings management through transaction structuring. As mentioned before, management can achieve a desirable accounting result by structuring transactions under rules- based accounting. The aforementioned survey suggests that there is a significant interaction between the precision of accounting standards and transaction structuring (Nelson et al. 2002, 193). Management is more likely to structure transactions when the standards are precise. Under principles-based accounting, management is required to exercise judgment when determining the accounting treatment for a particular transaction or event. To reduce the risk of litigation, management will have a stronger incentive to demonstrate that they have made a reasonable, good-faith judgment when determining the accounting treatment. Management may provide investors with more clear and transparent information about the economic substance of a transaction or event. This fulfills the purpose of the SEC by creating an incentive for companies to be more forthcoming in providing clear and transparent information to investors (SEC, 2003).

5. Investors a. Retail Investors Proponents of rules-base accounting often claim that detailed rules and bright-line tests increase consistency and comparability of financial information, which are the two primary qualities of decision-useful information. They believe that rules-based accounting standards allow similar transactions to be accounted for consistently, even by different companies. However, in the SEC Study, the SEC staffs argue that detailed rules and bright-lines can result in “illusory comparability” for two reasons (SEC, 2003). First, use of complex financial engineering to circumvent the rules may reduce the comparability of underlying economic substance. Second, if two arrangements are fundamentally the same but one meets the bright-line tests while the other does not, they may still be accounted for differently. Retail investors who have limited accounting knowledge will have difficulty in understanding the complex accounting rules under a rules-based accounting system. Since rules- based accounting standards contain many exception rules which deviate from the principles,

11 investors will be confused by the internal inconsistency in the accounting standards. Under a principles-based accounting system, the major benefit to the retail investors is that the accounting standards will be relatively easier to understand because principles-based accounting standards contain fewer exception rules than rules-based standards. Investors do not have to spend as much time as in the case of a rules-based accounting system.

b. Institutional Investors Given the huge amount of capital on hand, institutional investors invest in many different companies to diversify their risks. Analyzing the performance of different companies can still be a daunting task to the institutional investors because of the large amount of complex accounting rules under rules-based accounting. They have to spend a long time on understanding the complex rules and how the rules influence the financial performance of the companies. Under a principles-based accounting system, the cost of performing financial analysis will be lower because institutional investors can spend less time on understanding the accounting standards. However, institutional investors may not welcome the adoption of principles-based accounting because they may lose their competitive advantage. Institutional investors have abundant resources to hire people with sophisticated accounting knowledge. They have a competitive advantage in processing financial reports. This advantage may disappear if accounting standards become more understandable to investors. Institutional investors may prefer to keep this competitive advantage even at a higher cost.

Arguments for Why Principles-Based Accounting Is More Suitable to the U.S. Perhaps the strongest argument for principles-based accounting is that financial reporting should reflect the financial reality of the company (substance) instead of the legal form of the transactions (form) underlying them. Overemphasizing the form of the transactions may mislead the investors. Management of the companies can use complex transactions to disguise the reality of the transactions. In the Enron scandal, Enron was accused of using complex transactions to disguise its financial reality. Enron sold its underperforming assets to “outside” investors for more than it had originally paid for them, thus reporting big profits. However, Enron would fund and provide guarantees to the “outside” investors who bought the assets. Essentially the whole transactions were Enron selling underperforming assets to itself, removing the underperforming

12 assets from its book, and reporting substantial amount of fictitious profits. Most investors could not understand the economic substance of these complex transactions. The fictitious profits made the investors believe that Enron was an excellent company with good prospects, and the bankruptcy of Enron proved that they were wrong. Under a principles-based accounting system, companies are required to reflect the economic substance of transactions. No matter how complex the transactions they make, they still have to reflect the economic substance of those transactions. Therefore, they are unlikely to structure transactions. According to the SEC staffs, financial reporting may be viewed as an act of compliance rather than an act of communication in a rules-based accounting system (SEC, 2003). This is contrary to the objective of financial reporting because financial statements should serve as a means to communicate the performance of the companies to the external users. Complex and detailed rules under rules-based accounting make the financial statements less understandable to the investors. In a best-case implementation of principles-based accounting, financial statements will be easier to understand because the accounting standards capture the economic substance of the transactions. Another major argument for principles-based accounting is that rules-based accounting creates a vicious cycle, making accounting standards more detailed and complex. Under a rules- based accounting system, when the FASB sets rules specifying how a transaction should be accounted for, financial engineers will always find a way to circumvent the rules by structuring complex transactions so that they can achieve a desirable accounting result. When the FASB realizes that loopholes which may hurt the quality of the financial information exist, it will set a new rule to close the loopholes. The financial engineers will then find another way to circumvent the rules. The attempts by the FASB to close the loopholes and financial engineers to find loopholes go on and on, making the rules more and more complicated. As mentioned previously, the complexity of business transactions is one of the forces that drive U.S. GAAP to become more rules-based. The intent of the management to circumvent the rules leads to more complex transactions. Thus, it is fair to say that the complex rules are self-perpetuating. The vicious cycle may stop one day when the rules become too complicated and detailed that no one is able to comprehend. At that moment, people may start to demand for a shift to the principles-based accounting. The vicious cycle may also stop one day when a major accounting scandal shakes the confidence of everyone. At that time, people may step back and think about whether the

13 rules-based accounting system leads to the accounting scandal. This is what happened in the early 2000s when a series of accounting scandals involving corporate giants arose. Some people blamed the rules-based accounting system for leading to these major accounting scandals, and they demanded a shift to the principles-based accounting system. Rules-based standards also tend to reward those who are willing to structure transactions to circumvent the rules. Management can always achieve a desirable accounting result by creating more complex transactions. Two very similar transactions can be accounted for differently if the management of one company structures the transaction while the other does not. For example, a lease is considered a capital lease because the lease term is equal to 76 percent of the estimated economic life of the property. However, a similar lease is considered an operating lease because the management structures the transaction to make the lease term equal to 74 percent of the estimated economic life of the property. The financial result of the company which uses transaction structuring may look better than the other. When the investors do not realize that the two transactions are very similar and are misled by the financial result, they may draw a wrong conclusion that the company which structures its transaction is a better performer. In addition, people may perceive that the management of the company which structures transaction is doing a better job, so the management deserves a higher compensation. If management compensation is based on the financial result of the company, then the management who structures transaction will get a higher compensation. This is exactly what happened in the Enron scandal. Enron circumvented the accounting rules and created over hundreds of SPEs, shifting its debts and losses to the SPEs. As a result, Enron seemed to be doing a really good job compared to other companies. Its stock price skyrocketed, and investors had high expectations about its future prospects. Enron executives profited a lot from exercising their stock options. Of course, the bankruptcy of Enron revealed that the attractive performance of Enron was simply window- dressing – the financial reports did not reveal the economic substance of the performance.

Limitation of Principles-Based Accounting and Possible Remedies The major criticism of principles-based accounting is that reliance on judgment will reduce the comparability and consistency of financial information. It is true that principles-based accounting standards require the management and auditors to exercise judgment when applying the standards. A transaction may be accounted for differently by two different people because of

14 the difference in judgment. However, if the difference between people’s judgment is small, principles-based accounting can still provide a reasonable level of comparability and consistency. Several factors can affect the difference between people’s judgment. First, management will be more aggressive in financial reporting if they have high incentives to manage earnings. As mentioned previously, management compensation is often based on the financial performance of the company. Management will have higher incentives to manage earnings because they will receive a larger compensation. If the penalty on aggressive financial reporting is severe, management may be more conservative in financial reporting so as to avoid the heavy penalty. To reduce management’s incentive to manage earnings, compensation of management should be based on long-term operating and financial performance of the company. Second, management will be less aggressive in financial reporting if an effective enforcement mechanism is present. In the U.S., the main components of the enforcement mechanism include auditors, the committee, the SEC, and the legal system. The Sarbanes- Oxley Act of 2002 has strengthened the enforcement mechanism by ensuring the independence of the auditors and empowering the audit committee. Auditors and the audit committee are the first gate-keepers to the public securities markets. They are responsible for identifying the aggressive accounting practices of the management. If they fail to do so, then the second gate- keepers – the SEC and the legal system, come into play. They can impose penalties on companies that violate securities regulations. An effective enforcement mechanism deters management from aggressive financial reporting. Third, under a principles-based accounting system, the increased litigation risk will prompt management and auditors to make reasonable, good faith judgment that is based on the facts and circumstances available at the time. To avoid the risk of litigation, management will be less aggressive in financial reporting. If the cost of litigation is high, auditors will be more likely to require their clients to make adjustments when they determine that the accounting treatment for a certain transaction or event is inappropriate. Finally, accounting norms may also provide a reasonable level of comparability. Social norms of a group are the shared expectation of one another’s behavior held by the members of the group (Sunder 2005, 9). Mere majority support is inadequate. Social norms must be a consensus. In the accounting profession, the authority of accounting norms is derived from

15 general acceptance by the financial community and disapproval of deviations. These accounting norms set an expectation that everyone in the group should behave in a given manner, which reduces the discretion of accounting treatment. Management and accounting professionals will conform to the accounting norms because the norms are accepted by the financial community. Management will be less likely to be aggressive in financial reporting because it may violate the accounting norms. Existence of accounting norms will provide a reasonable level of comparability and consistency because management and accounting professionals will behave in a similar manner in order to conform to the norms.

Conclusion In this paper, I have discussed how the legal, economic, and regulatory environments drive U.S. GAAP to become more rules-based. Then I have examined the merits and drawbacks of rules-based and principles-based accounting systems from the standpoint of companies, auditors, financial analysts, the SEC, and investors. I have provided three arguments for why principles-based accounting is more suitable to the U.S. First, financial reporting should reflect the substance of a transaction, rather than its form. Second, rules-based accounting creates a vicious cycle, which leads to the increasing complexity of accounting rules. Finally, rules-based accounting tends to reward those who are willing to structure transactions to circumvent the rules. At the end of this paper, I have discussed the limitation of principles-based accounting and its remedies. The objective of financial accounting is to provide investors with information that helps them in making capital allocation decisions. Different stakeholders play a different role in the capital allocation process. Companies communicate their performance to the investors by providing them with financial information. Auditors provide a reasonable level of assurance that the information provided by the companies is reliable. Financial analysts study the information provided by the companies and make investment recommendation to their clients. The ideal role of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation by exercising its authority to bring civil enforcement actions against individual or companies alleged to have committed accounting fraud or provide false information. With the expectation that the accounting information provided by the companies is reliable, investors make investment decisions based on their own judgment or the recommendation made by

16 financial analysts. If the stakeholders fail to perform their own roles in the capital allocation process, capital will be misallocated. In the ideal capital allocation decision process, the goal of the FASB is to issue standards that reflect the economic substance of transactions and events, so that investors receive reliable information from the companies. To ensure the optimal allocation of capital, the FASB should issue more principles-based accounting standards that focus on the substance of the transactions.

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