Behavioral Evidence on the Effects of Principles- and Rules-Based Standards

I review research relevant to predicting how the behavior of various participants in the financial-reporting process is affected by principles-based and rules-based standards. I discuss standards in terms of being more or less rules-based, acknowledging that less rules-based standards must rely more on principles to guide behavior. I argue that adding rules affects the precision and complexity of an accounting standard. I review the incremental effects of rule precision and complexity on performance with respect to two important functions of financial-accounting standards: communication and constraint, with communication referring to the role standards play in conveying GAAP to practitioners, and constraint referring to the role of standards in discouraging biased communication. I review research from financial accounting, auditing, and tax, and I focus on evidence provided by experimental and survey studies. Regarding communication, the literature suggests that bright-line thresholds can be used in some circumstances to communicate accurately. However, the more general way to increase the precision with which a standard communicates is to increase the amount of specified decision process, detailed implementation guidance, examples, precedents and other rules that are in the standard, which also increases the complexity of the standard. Thus, standard setters face a tradeoff between including too few rules and creating a standard that communicates too vaguely and is interpreted inconsistently, versus including too many rules and creating a standard that becomes so complex that parts of it are applied incorrectly or missed entirely. Regarding constraint, the literature indicates that, regardless of the precision of standards, practitioners consciously or unconsciously make financial reports that are consistent with their incentives. Precise standards appear to help auditors discourage aggressive reporting when opportunities for transaction structuring are not available and/or clients are unaware of precise rules. However, incentive-consistent reporting choices often can be justified with respect to precise standards via transaction structuring or by aggressive interpretation of the evidence that is evaluated and compared to standards' requirements. And, if standards are imprecise, incentive-consistent reporting choices can be justified via aggressive interpretation of standards. Thus, incentive effects should be viewed as pervasive. If standard-setters and/or regulators desire accurate or conservative reporting, they are most likely to achieve it by combining (1) standards that are imprecise enough to avoid precise safe harbors, thereby allowing incentive-consistent interpretation to take place, and (2) vigorous enforcement activity that tilts the balance of incentives away from aggressive reporting and towards accurate or conservative reporting. Communication and constraint may operate at cross purposes under some circumstances, since the detail necessary to communicate accurately can also create opportunities for transaction structuring. In these cases, transaction structuring could be discouraged by basing guidance more on examples than bright lines, and by including "substance over form" provisions that are enforced when transactions are structured in a manner that is inconsistent with economic substance. The paper concludes with a brief discussion of changes in standards that are currently occurring or contemplated and that are consistent with the implications of existing research.