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

INTRODUCTION The Sarbanes-Oxley Act requires the SEC to study the feasibility of shifting to a more "principles-based" financial reporting system, and the FASB has proposed changes designed to create a more principles-based approach to standard setting (FASB 2002a). This commentary reviews research relevant to predicting how the behavior of various participants in the financial reporting process is affected by principles-based and rules-based standards. The "Incremental" Perspective Because U.S. accounting standards typically are written to operationalize the FASB's underlying conceptual framework, they are based on principles. The standards also provide guidance as to correct accounting or disclosure treatment, so they include rules. As a consequence, an immediate challenge in writing this commentary is to define exactly what it means for a standard to be "principles-based" or "rules-based." I restate the "principlesbased vs. rules-based standards" question in a way that is more conducive to extracting insights from the existing research literature. Assuming that the FASB continues to base standards on the framework of principles articulated in the FASB's concepts statements, all standards can be viewed as principles-based, and the issue is the incremental effect on behavior when standards include relatively more elaborate rules. Therefore, in this commentary I discuss standards in terms of being more or less rules-based, acknowledging that less rules-based standards must rely more on p rinciples to guide behavior. I define "rules" broadly to include specific criteria, "bright line" thresholds, examples, scope restrictions, exceptions, subsequent precedents, implementation guidance, etc. A "standard" is the total body of principles and rules that apply to a given accounting issue. This incremental perspective is useful in at least two ways. First, it focuses the review on the incremental effects of increasing the number of rules in a standard. I argue that adding rules affects the precision and complexity of an accounting standard, and consider the implications of studies that examine the effects of precision and complexity on the behavior of participants in the financial reporting process. Second, the incremental perspective may provide insight about the effect of varying the extent to which different standards appear to be principles-based or rules-based. Some accounting topics involve complex transactions with predictable characteristics, so it is possible to write standards that contain very specific thresholds. For example, leases typically involve physical assets and a contractually defined sequence of cash flows, and SFAS No. 13 (FASB 1976) uses numerical thresholds to specify criteria regarding the proportion of lease life and the amount of fair value. These sorts of accounting topics are amenable to rules, but do not necessarily require them, so standard setters must choose the extent to which the standard is to be rules-based. Other accounting topics have less predictable characteristics and more inherent judgment. For example, SFAS No. 5 (FASB 1975) involves estimates of probability and amounts that are not defined contractually. Because these topics are less amenable to rules or brig ht line thresholds, the standards that govern them are more principles-based by default. Finally, including precedents and implementation guidance in the definition of rules highlights that the extent to which a standard appears rules-based changes over time, as a particular standard accretes implementation guidance, interpretations, and technical rulings. One reason why relatively younger standard-setting regimes like the IAS appear more principles-based is that they have not had as much time to accrete rules. 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. …