rules-based and principles-based accounting standards and earnings management

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1 NiCE Working Paper 09-114 December 2009 Rules-Based and Principles-Based Accounting Standards and Earnings Management Ferdy van Beest* Nijmegen Center for Economics (NiCE) Institute for Management Research Radboud University Nijmegen P.O. Box 9108, 6500 HK Nijmegen, The Netherlands http://www.ru.nl/nice/workingpapers

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Page 1: Rules-Based and Principles-Based Accounting Standards and Earnings Management

1

NiCE Working Paper 09-114

December 2009

Rules-Based and Principles-Based Accounting

Standards and Earnings Management

Ferdy van Beest*

Nijmegen Center for Economics (NiCE)

Institute for Management Research

Radboud University Nijmegen

P.O. Box 9108, 6500 HK Nijmegen, The Netherlands

http://www.ru.nl/nice/workingpapers

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Abstract

We examine the effects that discretionary room in accounting standards has on both the level

and nature of earnings management decisions. To this end we design an experiment to test the

hypotheses that a rules-based setting induces managers to engage in earnings management

through transaction decisions, whilst a principles-based setting induces earnings management

through accounting decisions. Manipulations of IAS 32 and 36 are used to represent the rules-

based and the principles-based setting, and different analysts’ expectations act as incentives,

creating a 2x2 between-subjects design. In the rules-based setting managers more often sell

short-term financial assets, whereas in the principles-based setting managers are more prone

to taking impairment loss decisions. Combined results show that the rules-based and

principles-based treatments lead to comparable levels of earnings management. These results

suggest that changing the discretion in accounting standards may affect the nature of earnings

management, but is unlikely to prevent earnings management applications.

ACKNOWLEDGEMENTS

We gratefully acknowledge helpful comments from Ed Vosselman, Martin Hoogendoorn,

Ken Trotman, Paula van Veen-Dirks and André van Hoorn.

* The author is Ph.D. student in Accounting at the Nijmegen School of Management, Radboud University Nijmegen, The Netherlands.

Address: Radboud University Nijmegen, Nijmegen School of Management, P.O. Box 9108, 6500 HK

Nijmegen, The Netherlands. E-mail: [email protected]. Phone # +31(0)24-3611859.

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I. Introduction

Prior studies provide limited evidence on how reporting standards affect earnings

management (see Libby and Seybert 2009 for a recent overview). Libby et al. (2009) discuss

the importance of experiments and surveys for studying effects of reporting regulation on

earnings management. Hunton et al. (2006) examine the effect of transparency formats on

earnings management and conclude that increasing transparency requirements reduce the

extent of earnings management. Clor-Proell and Nelson (2006) examine whether principles-

based accounting standards, accompanied by implementation guidance, have an influence on

managers reporting judgment. Their results show that guidance accompanying less precise

standards could reduce earnings management.

Our focus is on the debate concerning rules-based and principles-based accounting

standards. The debate started after the ‘Norwalk’ agreement between the Financial

Accounting Standards Board (FASB) and the International Accounting Standards Board

(IASB) was signed meant to create more principles-based accounting standards for global

financial reporting (Clor-Proell et al., 2006). Archival studies show limited abilities to

estimate potential effects that regulatory changes have on encouraging or discouraging

earnings management (see Healy and Wahlen, 1999 for a review). Conversely, in an

experiment researchers are able to create their own setting, in which independent variables

can be manipulated and other potential effects can be controlled for, leading to stronger causal

inferences (Libby et al, 2009). Therefore, we use an experiment to test the influence of rules-

based and principles-based accounting standards on earnings management.

Although recent research indicates that discretionary room in accounting standards

affects earnings management decisions (Libby et al, 2009), findings on the question ‘how’

and ‘to what extent’ remain inconclusive. Nelson, Elliot and Tarpley (2002) examine the

effect of the precision of accounting standards related to several types of earnings

management. Their survey results show that managers are more likely to engage in earnings

management through transaction decisions in a rules-based setting, and similarly that

accounting decisions are used more in a principles-based setting. Similarly, Cohen et al.

(2008) report that firms switched from accounting decisions to transaction decisions after the

passage of the Sarbanes-Oxley Act in 2002. These results suggest that firms may change their

earnings management decisions, depending on the discretion given in accounting standards.

We use an experiment to investigate this issue further. The first question we seek to answer is

whether managers, in a rules-based setting, engage in earnings management through

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transaction decisions rather than through accounting decisions. The second question concerns

the opposite relation, whether in a principles-based area managers take accounting decisions

more often for the purpose of earnings management than transaction decisions.

In addition to testing this substitution effect, we reflect on the question how much

earnings management is applied in both a rules-based and a principles-based environment.

Research in this area also remains inconclusive. Nelson (2003) reviews this literature, including

some experimental studies, and concludes that the aggressiveness of reporting decisions

increases with an increase in flexibility in accounting standards. The findings of Psaros and

Trotman (2004), in contrast, show earnings management to be lower if accounting standards

are principles-based. Drawing on theses contradictory results, we use our experimental design

to investigate whether the discretionary room in accountings standards has an effect on the

level and nature of earnings management.

For our experiment, 175 financial managers chose between an impairment loss

decision and the opportunity to sell ‘available-for-sale’ securities. The impairment loss

decision refers to an accounting decision, whereas the selling of short term financial assets

refers to a transaction decision. The combined results of these two decisions allow us to assess

the effect rules-based and principles-based accounting standards have on the total degree of

earnings management. IAS 32 (Financial instruments) and IAS 36 (Impairment of assets)

were manipulated to fulfill the rules-based and principles-based requirements. Drawing on

Hunton et al. (2006) we include analysts’ consensus forecast as incentive to either increase or

decrease earnings, resulting in a 2x2 between-subject design. Results show that financial

managers are more likely to attempt earnings management through transaction decisions in a

rules-based setting rather than in a principles-based setting. Moreover, financial managers

engage in accounting decisions more often in a principles-based setting compared to a rules-

based setting. In addition, the combined results reveal that rules-based and principles-based

accounting standards do not differ significantly in the level of earnings management.

Overall, these results suggest that neither rules-based, nor principles-based accounting

standards are able to eliminate earnings management decisions. Confirming our theoretical

proposition, managers tend to adjust their decisions based on the latitude given in the

accounting standards. When standards are precisely specified, managers tend to search for

transaction opportunities to meet the pre-specified expectations. On the other hand, when

standards are imprecisely specified, managers use accounting decisions, such as an

impairment loss decision, to meet their incentives given. Finally, and most strikingly, the

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extent of discretion in the standards is found to have a small, statistically insignificant impact

on the average amount of earnings management managers include in their financial report.

Our study contributes in the area of rules-based and principles-based accounting

standards, and earnings management. First, we provide respondents a potential trade-off

between an accounting decision and a transaction decision. Although the relationship between

rules-based and principles-based standards and earnings management is commonly accepted

(Libby et al., 2009; Cohen et al., 2008; Nelson et al., 2002), this is the first experiment we are

aware off to provide this potential trade-off between accounting and transaction decisions.

Second, and contrary to most prior studies (inter alia Segovia et al., 2006), our study uses

financial managers to participate in the experiment rather than auditors. Third, and most

importantly, by means of an experiment, we test whether rules-based or principles-based

accounting standards affect the degree to which managers engage in earnings management;

providing clarity concerning the contradictory results found in prior research (for example

Nelson, 2003; Psaros and Trotman, 2004).

The remainder of this paper is as follows. In section two, background information is

provided and we develop our hypotheses. Section three and four describe the experiment used

to test these predictions and present the results of our experiment. Section 5 discusses the

implications of this study.

II. Background and hypotheses

Earnings management

Earnings management is extensively examined in academic research (See Libby et al., 2009;

Cohen et al., 2008 and Ronen and Yaari, 2008 for recent contributions). Commonly used

definitions come from Schipper (1989) and Healy and Wahlen (1999). Schipper (1989)

broadly defines earnings management as a purposeful intervention in the financial reporting

process, to obtain private gains. Healy and Wahlen (1999) are more concrete, finding that

earnings management occurs when agents deliberately use judgment and decision making in

financial reporting to mislead stakeholders about the economic performance or influence

contractual outcomes that depend on the financial report.

Two distinct possibilities to engage in earnings management are accounting decisions

and transaction decisions (Libby and Seybert, 2009; Cohen et al., 2008; Francis, 2001).

Accounting decisions refer to choices among equally acceptable rules and/ or judgment and

estimates required to implement GAAP (Libby and Seybert, 2009). Results from prior studies

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show that earnings management through accounting decisions may take place, amongst

others, in the areas of inventory measurement (Neill et al., 1995), revenue recognition (Bowen

et al., 2002) and fair value estimates (Mazza et al., 2007). Transaction decisions, on the other

hand, refer to choices of structuring transactions and contracts or adjust real production and

investment activities that are aimed at engaging in earnings management (Libby et al., 2009).

A non exhaustive list of transaction decisions examined in prior studies are strategic security

sales (Hunton et al, 2006), strategically use sale and leaseback transactions (Maines et al.,

2003; Imhoff and Thomas, 1988), and machinery replacement decisions (Jackson, 2008).

Accounting standards and earnings management

After some well-known reporting disasters at the beginning of the 21st century, the FASB and

IASB signed the ‘Norwalk’ agreement and started advocating a move towards a more

principles-based financial reporting system. This helps avoiding bright-line rules and in this

way allows for the exercise of more professional judgment (Clor-Proell et al., 2006).

Principles-based accounting standards refer to a system of financial reporting that is based

primarily on the fundamentals of accounting (decision usefulness, true and fair view, going

concern, substance over form) with an appropriate level of specificity (US SEC, 2002; Bennet

et al, 2006; Benston et al. 2006; Schipper, 2003; Psaros and Trotman, 2004); implying

extensive opportunities for professional judgment. These principles-based standards allow for

additional requirements; however, these requirements must be kept to a minimum and in

general are relatively soft. Relatively soft guidance, such as IAS 9.23, is that development

costs generally are amortized over a period not exceeding five years (Bennett et al., 2006),

leaving much room for professional judgment.

The Institute of Chartered Accountants of Scotland (ICAS, 2006) prefers a principles-

based system, amongst others because principles-based standards provide a comprehensive basis

and have the flexibility to deal with new and different situations. This flexibility, however, can

be used to engage in earnings management through accounting decisions. Therefore, Nobes

(2005) tend to prefer rules-based accounting standards. Rules-based accounting standards

refer to a system of financial reporting, that is based on detailed provisions of methods for most

accounting problems, where it is unambiguously clear how and when it is to be applied. Rules-

based accounting standards have very extensive and precise elaborations concerning what is

or is not allowed (Alexander and Jermakowicz, 2006). These precise standards hold the

advantage of increased comparability between financial reports, and create better

opportunities to verify reporting information for auditors (Nelson, 2003; Schipper, 2003).

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Moreover, rules-based standards largely eliminate opportunities to engage in earnings

management through accounting decisions (Nobes, 2005). A disadvantage, however, is that

the precise standards may be used for earnings management via transaction decisions (Nelson

et al., 2002). As a result, a trade-off remains between earnings management through

accounting decisions and earnings management through transaction decisions due to rules-

based and principles-based accounting standards.

Besides this potential trade-off, we reflect on the question how much earnings

management is applied in both a rules-based and a principles-based environment. Results in

this area remain inconclusive. Several experiments have been conducted to assess whether

rules-based or principles-based accounting standards are better able to diminish earnings

management. Nelson (2003) reviews some of this experimental literature and concludes that the

aggressiveness of reporting decisions increases with an increase in flexibility in accounting

standards, i.e. principles-based accounting standards create more earnings management

applications. This result is in line with Trompeter (1994). Trompeter (1994) uses audit partners

and varies the precision of accounting standards in a marketable security valuation case. He

shows that audit partners allow for more income-increasing interpretations in cases with less

precise standards.

Contrary to these results, however, Psaros and Trotman (2004) and Segovia and

Arnold (2006) show results that principles-based accounting standards perform better in

diminishing earnings management. Psaros and Trotman (2004) examine whether rules-based

standards or principles-based standards influence preparers’ judgment to consolidate more, i.e.

influence preparers’ judgment to combine financial reports of several related companies. One

conclusion is that consolidation judgments (whether or not to consolidate) appear to be

influenced more in a rules-based setting than in a principles-based setting with regard to their

decision beforehand. The preparers use the presented information more aggressively, i.e. select

the reporting disclosure that portrays events favorably when the position is not indicated clearly

to comply with the rules. With the same incentive not to consolidate, the influence of additional

information was larger in a rules-based setting (Psaros and Trotman, 2004). Segovia and Arnold

(2006) confirm these results by showing that U.S. auditors are more willing to allow earnings

management under rules-based standards.

To conclude, we distinguish between accounting decisions and transaction decisions to

engage in earnings management. Our study focuses on the influence discretion in accounting

standards has on both the type of earnings management applied as well as the degree to which

managers take earnings management decisions.

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Hypotheses

For developing our hypotheses, we start with principles-based accounting standards. We

expect managers to engage in accounting decisions more in a principles-based setting than in

a rules-based setting (Nelson et al., 2002). Principles-based standards leave more room for

professional judgment. This flexibility, however, may also be used to engage in earnings

management (Nobes, 2005; Schipper, 2003; Nelson, 2003). Managers may use the substance-

over-form discussions to convince the auditor concerning the economic reality of the account.

Therefore, firms use the accounting policy choices given or estimate opportunities provided to

meet their incentives. These opportunities are not included in rules-based standards. As a

consequence, Nobes (2005) concludes that rules-based standards reduce opportunities for

earnings management through judgment (accounting decisions). To conclude, in the area of

earnings management, we expect managers to engage in accounting decisions more in a

principles-based setting compared to a rules-based setting.

Hypothesis 1a: Managers engage more in accounting decisions in a principles-based

setting than in a rules-based setting.

To ‘solve’ this problem related to principles-based standards, standard setters can

decide to add requirements and thereby decrease the opportunities left to engage in earnings

management through accounting decisions. By adding requirements, standards become more

rules-based (Nelson, 2003). We expect that managers are more likely to use transaction

decisions, when accounting standards are rules-based rather than principles-based standards.

Nelson et al. (2002) examine the effect of precision of accounting standards on the various

types of earnings management. Their survey results show that if structured decisions comply

with precise rules, such as numerical thresholds, auditors are less likely to require

adjustments, even if financial results deviate from the substance-over-form expectations.

Similarly, since principles-based standards lack numerical thresholds, adjusting contracts in a

principles-based setting seem useless because auditors may still require material adjustments

(Nelson et al., 2002). Consequently, managers are more likely to attempt earnings

management using transaction decisions in a rules-based setting than in a principles-based

setting.

Hypothesis 1b: Managers engage more in transaction decisions in a rules-based setting

than in a principles-based setting.

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When we combine these results, we expect no significant differences in the degree of

earnings management between rules-based and principles-based accounting standards for

three reasons. First, because we hypothesize that managers engage in earnings management

anyhow; either via accounting decisions in a principles-based area or via transaction decisions

in a rules-based area. Second, prior research suggests that when incentives are sufficient to

attempt earnings management practices, neither rules-based, nor principles-based accounting

standards are able to fully eliminate earnings management decisions (Nelson, 2003). Third,

since prior literature shows contradictory results concerning the effects rules-based and

principles-based accounting standards have on earnings management. Inter alia, Gibbins et al.

(2001) note that rules-based standards increase auditors’ power when negotiating with its

client to diminish earnings management. Segovia and Arnold (2006), however, show greater

acceptance of earnings management decisions in a rules-based environment. Therefore, since

both theoretical reasoning as well as prior research show ambiguous expectations in this area,

we hypothesize that no significant differences will occur in the degree of earnings

management when we compare rules-based and principles-based settings.

Hypothesis 2: The degree of earnings management does not differ between a rules-

based and a principles-based setting.

III. Research method

In our experiment, 175 financial managers decided on both an available-for-sale security to

sell and an impairment loss decision to consider; an opportunity to take an accounting

decision and a transaction decision to engage in earnings management. We manipulated IAS

32 and IAS 36 for representing the rules-based and principles-based setting, and manipulated

analysts’ expectations creating a 2x2 between-subjects design.

Subject selection

There is a large literature debating whether or not students are appropriate as participants for

accounting experiments. Amongst others, Chang and Ho (2004) show that using students is

inappropriate for professional decision making. They compare 222 experienced managers

with 146 undergraduate students. One of their conclusions is that students show little

sensitivity to contextual information. Potters and Van Winden (2000) confirm this

expectation. Using a lobbying experiment, they find a significant difference between students

and professionals, based on professional rules of conduct. Finally, Hunton et al. (2006) use 62

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financial executives for their study because they aim ‘to peer into the minds’ of experienced

managers. Comparable to Chang and Ho (2004), Potters and Van Winden (2000), and

Hunton, Libby and Mazza (2006) we use experienced respondents. Our goal is to peer into the

minds of professional managers (CFO’s), who are aware of the effects of their financial

reporting decisions taken.

The participants are ‘Register Controllers’ (RC’s)1 connected to the ‘Vereniging van

Registercontrollers’. Of the 175 participants, 124 (71%) currently work as a controller/CFO.

The demographics of our respondents are displayed in Table 1.

< Table 1 about here>

Task

Appendix 1 gives full details of the experimental task.2 The case material asks participants to

assume they work as CFO for a quoted company. It is December 19, 2009, and before

finishing the year-end financial report two decisions must be taken. Before the decisions taken

by the participants, net profit of Snilco Inc. ends up at approximately € 50 million. The first

decision concerns taking an impairment loss decision. Drawing on Segovia and Arnold (2006)

and Riedl (2004) we use this impairment loss decision to proxy for earnings management

through an accounting decision. The participants learn that the companies’ building stands on

polluted ground. As a consequence, and in conformity with the accounting standard, the value

of this fixed asset (including ground), with a carrying value of € 25 million, must be impaired.

For assessing the impairment loss, the company has consulted two appraisal offices. The

non-earnings management position in this part would be the assessed impairment loss as stated

by the very renowned and domestic appraiser from Appraisal Office A;3 leading to an

impairment loss of € 10 million. Our case provides two opportunities to deviate from the

assessment of this renowned assessor. First, a more local appraiser is hired, which assesses

roughly that the value of the companies’ building is € 10 million; companies’ financial result

would decrease with € 15 million, leading to an attempt in earnings management (decrease) of

€ 5 million. Secondly, the case includes a statement concerning the previously sold building

1RC’s are highly educated controllers that receive this official title after finishing two or three years of

postmaster education combined with at least three years of practical experience; roughly comparable with being

a chartered controller. Similarly, RA in Table 1 is an abbreviation for ‘Register Accountant’, which is closely

comparable to a CPA. 2The case material included in appendix 1 is written in English. The original case for conducting the experiment,

however, was in Dutch, because all our respondents were native Dutch. 3 Although this argument can be debated, we verified in our post debriefing analysis whether participants find

the assessment of Appraisal Office A the most ”objective”. The participants confirmed this statement (74% was

neutral to fully agreed).

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of their neighbors. Since the selling price was € 20 million, this would result in an impairment

loss of € 5 million, i.e. an earnings upgrade with € 5 million.

Our second decision holds an earnings management through transaction decision.

Comparable to Hunton et al. (2006), we provide an opportunity to sell short term financial

assets. Portfolio Y holds an unrealized gain of 5 million, whereas portfolio Z holds an

unrealized loss of 5 million. By selling this portfolio, subjects are able to either increase or

decrease net earnings. The non earnings management position is represented by not selling

any short term financial assets, because the case explicitly states that selling these financial

assets is not necessary to fulfill liquidity requirements. In conformity with IAS 32 and 39, we

allow preparers to hold unrealized losses in the owners’ equity part. Hence, the case exposes

that realisation of unrealized gains and losses are due after selling the portfolio. For testing

our second hypothesis, we combine both results from the accounting and transaction decision.

Table 2 summarizes all potential case outcomes.

< Table 2 about here>

Experimental design

Thus far, the possibilities to take earnings management decisions are equal under both a rules-

based and a principles-based treatment. To answer the case questions, participants read their

analysts’ consensus forecast and their accounting standards to comply with. We manipulate

IAS 364 (Impairment of assets) and IAS 32 (Financial instruments) for representing the rules-

based and the principles-based setting, and use different analysts’ expectations as incentives,

creating a 2x2 between-subjects design.

The artificial accounting standards to consider for the impairment loss decision, based on IAS

36, are presented as follows:

Principles-based (PB):

(b) If there is no binding sale agreement or active market for an asset, fair value less costs to

sell is based on the best information available to reflect the amount that an arm’s length

transaction between knowledgeable, willing parties, after deducting the costs of disposal. In

determining this amount, an entity may consider the outcome of an assessment of an expert.

4 We use the IASB standards as bases and adjusted these standards to fulfill rules-based and principles-based

requirements. This choice, however, was quite arbitrary. We could have chosen the FASB-standards equally well

as a starting point of our operationalization process. The IASB standards for our issues, however, were easier to

adjust. In this way we overcome influential, non-controllable factors, since the accounting standards can convey

unintended information about the nature of the underlying theory to be tested (Libby et al., 2002).

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Rules-based (RB):

(b) If there is no binding sale agreement or active market for an asset, fair value less costs to

sell is based on the best information available to reflect the amount that an arm’s length

transaction between knowledgeable, willing parties, after deducting the costs of disposal. In

determining this amount, an entity must adopt the primary outcome of an assessment of a

renowned expert. If the company decides to deviate from this assessment, an entity must

disclose why they have chosen this valuation and what the impact was on the financial results.

A first distinction concerns the difference between ‘may consider’ and ‘must adopt’. ‘May

consider’ inherently accepts professional judgment whether or not to comply with this

standard, referring to the principles-based setting. CFO’s may use their ‘true and fair

override’ if in their view the situation deviates from the outcome of the accounting standard.

Moreover, we explicitly included ‘renowned’ in the rules-based standard. This phrase is

comparable to the case description and emphasizes the form over substance (RB). Finally, we

included a ‘disclosure obligation’ for the rules-based setting to deal with; only if a CFO

decides to deviate from the renowned expert. This obligatory requirement in the rules-based

setting refers to the limited choices CFO’s have in practice due to the stringency of

accounting standards.

The artificial standards concerning selling financial assets for the rules-based and principles-

based setting are displayed as following:

Principles-based (PB):

If necessary or wishful to enhance the insights of financial statement users, the company is

allowed to separately disclose the amount that was removed from equity and recognized in

profit or loss for the period. An entity may disclose material items of income in profit or loss or

as a separate component of equity.

Rules-based (RB):

The company should at least disclose all material items for the amount that was removed from

equity and recognized in profit or loss for the period. An entity shall disclose material items of

income in profit or loss or as a separate component of equity.

The distinction between rules-based and principles-based starts with the phrase ‘If necessary

or wishful to enhance the insights of financial statement users’ in the principles-based setting.

This phrase, obviously lacking in the rules-based setting, emphasizes the importance of

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professional judgment in deciding whether this decision seems useful to financial statement

users. In addition, the distinction between the company ‘is allowed to disclose’ (PB) and

‘should at least disclose’ (RB) stresses the distinction of professional judgment and flexibility

(PB) on the one hand vis-à-vis with what one ought to do on the other hand (RB). Finally, the

notions ‘may’ versus ‘shall’ again represent a difference in which the situation of what a CFO

can do (PB) is compared to the mandatory representation in the rules-based setting.

In addition to these accounting standards, Libby and Seybert (2009) stress the importance of

including appropriate incentives when conducting an accounting experiment to increase

internal validity. Following Baik and Jiang (2006), Hunton et al. (2006) and Libby and

Kinney (2000), we include analysts’ forecast as incentive to influence financial outcomes.

Including analysts’ consensus forecast provides us with a neutral yet relevant opportunity to

influence CFO’s decision making. Projected earnings for the non earnings management

situation are € 40 million. Drawing on Hunton et al. (2006), we vary analysts’ consensus

forecast between € 45 million and € 35 million, providing participants an incentive to either

increase or decrease net earnings. This 2x2 design is displayed in Table 3, including the

number of participants that finished the research (175 participants in total).

< Table 3 about here>

Procedure

From the ‘Vereniging voor Register Controllers’ (VRC) we have received a batch of 2,340

email addresses. This batch included all chartered controllers in the Netherlands. We

randomly assigned respondents to one of the four treatment level via

http://www.randomizer.org. Using this method overcomes problems of researcher

interference and thereby contributes to the internal validity of our experiment. To control our

budget, and in line with Libby et al. (2002), we used an online application rather than a

laboratory for executing our experiment. The online application we used was

‘Netquestionnaire’ (www.netq.nl).

In addition to the provided case, a link was created to inform subjects about their

accounting standards; either rules-based or principles-based accounting standards. These

accounting standards were accessible via a hyperlink in the case; Appendix (Bijlage).

http://fbw.ruhosting.nl/ferdy/abba67.html presented the obligatory principles-based standards,

whereas http://fbw.ruhosting.nl/ferdy/bastiaan24.html showed the rules-based accounting

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standard to comply with.5 The accounting standards were exposed on less than one page (see

Appendix 2 and 3). Moreover, the case displayed analysts’ consensus forecast, either € 45

million or € 35 million depending on the treatment level.

Subjects were allowed to participate in the experiment between September 28, 2009

and October 14, 2009. The introduction included a phrase that the research will last

approximately 15 minutes. To thank participants for their cooperation we promised to donate

€ 5 to a charity fund of their choice. Our application registered IP-addresses; subjects were

only allowed to participate once. The application did not allow participants to look back.

Hence, they were unable to verify the case when answering the manipulation check questions.

Moreover, the application prevented participants to adjust their decisions taken after

becoming aware of the research questions.

IV. Results

Hypotheses testing

In section 2 we developed our hypotheses. We expected more accounting decisions in a

principles-based setting (hypothesis 1a), whereas we expect more transaction decisions in a

rules-based setting (hypothesis 1b). Moreover, we expect similar results for the rules-based

and principles-based setting when concerning the total degree of earnings management.

(hypothesis 2). Table 4 presents the frequencies of the impairment loss and security sale

decisions taken. Table 5 reports on the total effect these both decisions have on reported

earnings. Table 6 displays the Anova analyses.

< Table 4 about here>

< Table 5 about here>

To test our first hypothesis, we compare the number of accounting decisions taken between a

rules-based and a principles-based setting. Hence, we compare the number of participants that

either chooses € 5 or € 15 million to include as an impairment loss and compare this number

of decisions for both the rules-based and principles-based setting. The results from Table 4

5 We deliberately decided to have very dissimilar links used. By using these links, subjects are unable to ‘guess’

what the website of the other accounting standards might be.

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15

show that 17 participants (out of 83; 20,48%) take an accounting decision in the principles-

based environment, whereas 13 out of 92 (14,13%) participants take an accounting decision in

the rules-based environment. Using an ANOVA-test, we test whether this hypothesis is

statistically confirmed. The results from our Anova analysis are presented in Table 6, Panel

A. As indicated in Table 6, the difference between rules-based and principles-based is

insignificant (p = 0.134). However, when we compare the accounting decisions taken between

the rules-based and the principles-based setting (analysts’ forecast 45), the p-value (p = 0.074)

indicates a significant difference at the 10% level.6

Comparable to hypothesis 1a, hypothesis 1b is tested by comparing the number of

transaction decisions taken under both accounting regimes. Not selling these short term

financial assets represents the non earnings management decision. Selling either portfolio Y

or Z is considered to be an earnings management through transaction decision. The results

from Table 4 show that 30 participants in the rules-based area and 19 participants in the

principles-based area (32,61% and 22,89%, respectively) decide to take a transaction decision.

Using an ANOVA-test, we find that significantly more participants under the rules-based

treatment decided to take a transaction decision compared to transaction decisions taken in the

principles-based treatment (p = 0.076).

< Table 6 about here>

More importantly, we test the trade-off between accounting and transaction decisions taken.

Prior research (inter alia Nelson et al., 2002; Cohen, 2008) demonstrate the contribution rules-

based and principles-based standards have on the type of earnings management decisions. To

test whether trade-offs made deviate between a rules-based and a principles-based setting, we

compare the relative proportions of transaction decisions versus accounting decisions taken in

the rules-based and principles-based treatments. To measure this relative proportion, we

subtract the number of accounting decisions taken from the number of transaction decisions

taken. Because we expect more transaction decisions in a rules-based environment and more

6 Using one sided testing is used more often in prior literature (for instance Hunton et al., 2006). Turning to the

statistical significance of our results, we find the estimates are somewhat imprecise, only reaching significance at

the 10% level. Upshot is that we should take some care not to draw too strong conclusions from our

experimental findings. On the other hand, our experimental design did not contain the high-powered incentives

that are likely to exist in the real world. As such, finding statistically significant differences between the two

accounting standards shows how important these standards are likely to be in shaping real world earnings

management decisions. Of course, it also resonates with the strong theoretical rationale for expecting differential

effects of the two accounting standards on accounting decisions and transaction decisions.

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accounting decisions in a principles-based environment, our results can be tested one sided;

expecting a significantly higher result in the rules-based area. Our results confirm this

expectation (p = 0.053). To conclude, our results demonstrate that in the rules-based setting,

managers tend to take the opportunity to sell short term financial assets more, whereas

relatively, in the principles-based setting, managers more often take impairment loss

decisions.

Based on the accounting and transaction decision taken, we are able to deduce

respondents’ net earnings. The results are displayed in Table 5. The results can ultimately

deviate between € 30 and € 50 million (see Table 2), with € 40 million representing the non

earnings management situation. The effect of analysts’ forecast has a larger effect when

income increasing incentives are involved compared to the income decreasing incentives.

Moreover, the average results of rules-based (40.82) and principles-based (41.20) accounting

standards suggest that accounting standards have a significant influence on earnings

management decisions, which is statistically confirmed for principles-based and rules-based

accounting standards (p = 0.001 and p = 0.021, respectively).

In addition to testing hypotheses 1a and 1b, Table 6, Panel B relates to whether

subjects actually engage in earnings management. Participants with an incentive to increase

earnings truly attempt in earnings management practices with a significance of p < 0.01 for

both the rules-based and the principles-based treatment. Surprisingly, however, our

participants do not significantly engage in earnings management, when they receive analysts’

forecast 35 as incentive to decrease earnings. Although on average, net earnings are lower

than the non earnings management situation (average difference of 0.33), these average

results are insignificant (p = 0.146).

The more interesting question, however, relates to hypothesis 2. This hypothesis

reflects on the question which type of accounting standards is better able to prevent earnings

management applications. For testing hypothesis 2 we need a two sided t-test. Results in

Table 6 (Panel B) show that neither when income increasing incentives are involved, nor

when income decreasing incentives are involved, there is a significant difference between the

degree of earnings management under a rules-based and principles-based regime (p = 0.655

and p = 0.526, respectively).

Overall, when incentives are sufficient to engage in earnings management, neither

rules-based, nor principles-based accounting standards are able to eliminate earnings

management decisions (see Table 6). This confirms expectations from prior research (e.g.

Libby et al., 2009; Nelson, 2003) suggesting that incentives have a bigger influence on

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earnings management than accounting standards. When standards are precise, managers tend

to search for transaction opportunities to meet analysts’ expectations. When standards are

imprecise, managers more often take accounting decisions, such as impairment loss decisions,

to meet their incentives given. Most striking, however, is that the discretion in the standards

does not have a significant influence on the degree of earnings management managers include

in their financial report.

Manipulation checks

Manipulation check questions directly relate to the case displayed and verify whether

respondents understood the case correctly. This is important to guarantee the internal validity

of the case (Libby et al., 2002). In state of the art experimental papers, such as Hunton et al.

(2006), manipulation check questions are asked after the provided case. For our study,

however, we asked participants to record the correct accounting standards prior to answering

on the accounting and transaction decision. Given that we use an artificial accounting

standard, we face the risk that participants do not read the provided standard carefully enough,

which could harm our results. Participants were only allowed to continue after a correct

assessment of the accounting standards provided.

In addition to the manipulation check questions verifying which accounting standards

participants had to comply with, we asked three additional questions concerning the exposed

case description. First, we verified what the effect would be, if they had chosen to base their

impairment loss decision on appraisal office B. Second, we asked participants to record

whether the selling of ‘available for sale’ securities provided an opportunity to create both an

additional loss and/ or a gain. Third, we asked what the analysts’ consensus forecast for 2009

was. Since on average, 93 percent of the participants answered the manipulation checks

correctly, we deem the experimental design successful.

V. Conclusion

Recent research indicates that the discretion in accounting standards has an influence on

earnings management decisions (Libby et al, 2009). By means of our experiment, involving

175 RC’s, we test which effects rules-based and principles-based accounting standards have

on earnings management. Confirming our prior expectations (Nelson, Elliot and Tarpley,

2002), managers tend to adjust their decisions based on the latitude given in the accounting

standards. Our results show that participants in a rules-based setting are more likely to use

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transaction decisions, selling ‘available for sale’ securities. Moreover, participants in the

principles-based setting more often use their impairment loss (accounting) decision to engage

in earnings management compared to participants in the rules-based setting. Furthermore, our

results demonstrate that when incentives are sufficient to attempt earnings management

practices, neither rules-based, nor principles-based accounting standards are able to fully

eliminate earnings management decisions. Most striking, however, is that the nature of the

accounting standards provided does not have a significant influence on the average amount of

earnings management participants included in their financial reports. These results suggest

that increasing or decreasing the flexibility in accounting standards may hardly be useful to

prevent earnings management applications and will only result in a substitution effect;

creating different types of earnings management applications.

Our study contributes in the area of rules-based and principles-based accounting

standards, and earnings management. First, and contrary to most prior studies (e.g. Nelson et

al., 2002), our study uses financial managers to participate in the experiment rather than

auditors. Second, we provide respondents a potential trade-off between an accounting

decision and a transaction decision. Although the relationship between rules-based and

principles-based standards and earnings management is commonly accepted (Libby et al,

2009; Nelson, 2003), this is the first study we are aware off to provide this potential trade-off

between accounting and transaction decisions. Third, and most importantly, our study

contributes to the question which type of accounting standard is better able to diminish

earnings management. In line with contradictory results found in prior research our results

demonstrate that neither rules-based nor principles-based accounting standards are better able

to reduce earnings management practices.

This study may be useful to the FASB and IASB. Continuing with the convergence

project, one of the issues they face is how much discretion to allow for when developing new

or adjusting existing accounting standards. Although both boards signed the ‘Norwalk

agreement’ with the intention to create more principles-based accounting standards for global

financial reporting (Clor-Proell et al., 2006), accounting standards seem to become more

rules-based. From an earnings management perspective, however, our results do not show a

fundamental difference between rules-based or principles-based accounting standards in their

ability to prevent earnings management. Standard setters may contemplate our experimental

results when discussing the direction they are heading for developing future accounting

standards.

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Our study, however, holds several limitations. First, we provide participants with only

limited information to take their accounting and transaction decision. Although enriching the

study might contribute to creating more external valid results, we believe that leaving

participants with a relatively simple design strengthens causal inference. Second, we use

artificial standards rather than existing accounting standards. Although we use IAS 32

(Financial instruments) and IAS 36 (Impairment of assets) as a basis for manipulation, our

standards remain artificial. Third, we use only two positions on the rules-based and

principles-based continuum, whereas we could have chosen intermediary types as well. Such

tests could be conducted in future research. Finally, and similar to Hunton et al. (2006) we

provide respondents with only one incentive, whereas in daily practice financial managers

have various incentives, and we offer respondents only two ways to manage earnings. We

recognize that CFO’s in practice may have more than two opportunities for earnings

management attempts and perceive various incentives both to increase and decrease earnings.

Future researchers may want to include more distinct incentives and earnings management

opportunities.

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Appendix 1: Snilco Case (English, original in Dutch)

Introduction

You are about to participate in a research which contributes to a better understanding of the

decision-making of financial managers. You will be asked to take decisions, for which there

are no correct or incorrect answers. Although you normally might prefer to receive additional

information for such decisions, the purpose is to take decisions based on the presented

information. Try to answer the questions comparable to decisions during common practice,

i.e. like you would normally do.

This research exists of three parts. In part one a casus is described, which you must read

carefully and thereafter you must answer the two requested decisions. Afterwards you will be

asked to answer questions directly related to the casus and questions concerning individual/

personal characteristics.

The total research will last approximately 15 minutes. To thank your for your cooperation, we

would like to donate € 5, - to a charity fund, which you can indicate at the end of the research.

On behalf of the charity funds and the research group we would like to thank you for your

participation in advance. The data are treated confidentially and will be used for scientific

purposes only.

You are the CFO of Snilco Inc.

Snilco Inc. is a quoted company, which, as a subcontractor, supplies companies with

manufactured steel aid constructions for machinery. The company generally delivers good

financial results and has a stable stock exchange rate.

It is December 19, 2009, and you are currently working on the preparation of the companies’

financial results of 2009. Following current calculations, net profit of Snilco Inc. will end up

on approximately € 50 million. However, as Snilco’s CFO you must first manage two issues.

1. First of all, two months ago, you received a bulletin from the municipality which stated that

Snilco’s building, with a carrying value of € 25 million, stands on polluted ground. After

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consultation of the auditor and in conformity with the accounting standard you decided to

request an appraisal office to assess the value of the building.

Appraisal office A is very renowned, has a domestic coverage and already looked after

several projects for Snilco Inc. in the past. They assess the current value of the building and

ground as € 15 million, which implies an impairment loss of € 10 million. The results will be

taken very seriously by the Supervisory Board. However, two months ago, you discovered

that the neighbours’ building, a fairly comparable building that also stands on polluted

ground, was sold for € 20 million. Moreover, you have asked a less renowned appraisal office

B. They have assessed that the current value is € 10 million.

Schematically this could be presented as following:

(€ in millions) Appraisal

office A

Appraisal

office B

Neighbours'

building

Carrying value € 25 € 25 € 25

Assessment current

value€ 15 € 10 € 20

Impairment loss € 10 € 15 € 5

2. Beside the impairment loss decision, you can also choose to sell a portfolio of `available for

to sale' securities. You may choose between portfolios Y or Z. Portfolio Y holds an unrealized

gain of € 5 million, whereas portfolio Z holds an unrealized loss of € 5 million. Although it

will have not a significant influence on the companies’ financial result, selling available for

sale securities implies transaction costs. An explicit remark for this purpose is that you do not

need the released cash from the selling of the securities to create a balance in your liquidity

budget. In accordance with the accounting standards, one is not obliged to include an

unrealized loss in the financial statement, if this loss is expected to be of temporary nature. In

other words, both the unrealized loss and the unrealized gain will be realized at sale.

As a quoted corporation, it is important to meet the analysts’ and investors’ expectations.

Year after year Snilco succeeded in meeting analysts’ forecast, leading to a relatively high

share price for the company. A high share price is important to remain `healthy'.

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The analysts’ consensus forecast for your company’s 2009 earnings is € 45 million [€ 35

million].

For audit purposes, it is important that you comply with the financial reporting rules. You

must take decisions in accordance with these rules. You must use the rules as given in the

appendix. Click on the following link to open your accounting standard:

1. Based on the above given case description and accessory accounting standard, you are

asked to assess the impairment loss you consider to include in the annual report. Which

amount will you include as impairment loss?

• 10 million (similar to the assessment of appraisal office A)

• 5 million (similar to the sold neighbours’ building)

• 15 million (similar to the assessment of appraisal office B)

2. In addition, you have the opportunity to sell ‘available for sale’ securities. Based on the

above given case description and accessory accounting standard, what decision will you take

concerning the selling of your portfolio?

• Sell portfolio Y (5 million additional gain)

• Sell portfolio Z (5 million additional loss)

• Don’t sell

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Appendix 2: Accounting standard with regard to impairment loss (principles-based)

1. In assessing whether there is any indication that an asset may be impaired, an entity shall

consider the following situations:

(a) during the period, an asset’s market value has declined significantly more than would be

expected as a result of the passage of time or normal use;

(b) evidence is available of obsolescence or physical damage of an asset.

2. When the fair value less costs to sell is lower than its carrying amount, the assets must be

impaired to its’ fair value less costs to sell value. The difference between the fair value less

costs to sell and its’ carrying amount must be included as impairment loss in the profit and

loss account.

(b) If there is no binding sale agreement or active market for an asset, fair value less costs to

sell is based on the best information available to reflect the amount that an arm’s length

transaction between knowledgeable, willing parties, after deducting the costs of disposal. In

determining this amount, an entity may consider the outcome of an assessment of an expert.

Accounting standard with regard to available for sale impact

1. If necessary or wishful to enhance the insights of financial statement users, the company is

allowed to separately disclose the amount that was removed from equity and recognized in

profit or loss for the period. An entity may disclose material items of income in profit or loss

or as a separate component of equity.

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Appendix 3: Accounting standard with regard to impairment loss (rules-based)

1. In assessing whether there is any indication that an asset may be impaired, an entity shall

consider the following situations:

(a) during the period, an asset’s market value has declined significantly more than would be

expected as a result of the passage of time or normal use;

(b) evidence is available of obsolescence or physical damage of an asset.

2. When the fair value less costs to sell is lower than its carrying amount, the assets must be

impaired to its’ fair value less costs to sell value. The difference between the fair value less

costs to sell and its’ carrying amount must be included as impairment loss in the profit and

loss account.

(b) If there is no binding sale agreement or active market for an asset, fair value less costs to

sell is based on the best information available to reflect the amount that an arm’s length

transaction between knowledgeable, willing parties, after deducting the costs of disposal. In

determining this amount, an entity must primarily adopt the outcome of an assessment of a

renowned expert. If the company decides to deviate from this assessment, an entity must

disclose why they have chosen this valuation and what the impact was on the financial results.

Accounting standard with regard to available for sale impact

1. The company should at least disclose all material items for the amount that was removed

from equity and recognized in profit or loss for the period. An entity shall disclose material

items of income in profit or loss or as a separate component of equity.

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Table 1: Demographic data

Number Percent

Formal Certifications held by participants

RC 175 100%

RA 17 10%

MSc. 128 73%

other: 26 15%

Participants employed as controller/ CFO 124 71%

Male 151 86%

Female 24 14%

Mean* SD

Average business experience 10.8 5.6

Age 40.7 6.8

* based on Anova testing, response means do not significantly differ across treatment levels

Table 2: Case outcomes

Table 3: 2x2 operational experimental design (including number of participants)

Rules-based (adj IAS 36

and adj IAS 32/39)

Principles-based (adj IAS

36 and adj IAS 32/39)

Analysts’ forecast 45 44 41

Analysts’ forecast 35 48 42

Portfolio Z (-5) & (-5)

Appraiser B

Portfolio Z

(-5) & (0)

Appraiser A

No security

sale

(0) & (-5) Appraiser B

Portfolio Z

(-5) & (+5)

Neighbours’

building

No security

sale

(0) & (0)

Appraiser A

Portfolio Y

(+5) & (-5)

Appraiser B

Portfolio Y (+5) & (0)

Appraiser A

No security

sale

(0) & (+5)

Neighbours’

building

Portfolio Y (+5) & (+5)

Neighbours’

building

€ 30 M. € 35 M. € 40 M. € 45M. € 50 M.

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Table 4: Decisions (impairment loss and security sale decisions)

Impairment loss Appraiser A Appraiser B Total

(-10) (-15)

PB (45) 31 0 10 41

PB (35) 35 4 3 42

Total 66 4 13 83

RB (45) 37 1 6 44

RB (35) 42 4 2 48

Total 79 5 8 92

Security sale No sale Z Y Total

0 (-5) (+5)

PB (45) 28 1 12 41

PB (35) 36 3 3 42

Total 64 4 15 83

RB (45) 27 1 16 44

RB (35) 35 8 5 48

Total 62 9 21 92

Neighbours'

building (-5)

Table 5: Net earnings

Rules-based Principles-based Effect analysts’

forecast

Analysts’ forecast 45 42.27 (2.94) 42.56 (2.98) 42.41 (2.95)

Analysts’ forecast 35 39.47 (3.14) 39.88 (2.81) 39.67 (2.98)

Effect Accounting standards 40.82 (3.34) 41.20 (3.18)

Table 6: Anova analysis

Panel A

t-statistics Sign.

Accounting Decisions:

20.48% (PB)> 14.13 % (RB) (one sided t-test) 1.111 0.134

Transaction decisions:

32.61% (RB) > 22.89% (PB) (one sided t-test) -1.438 0.076*

Transaction decisions- Accounting Decisions:

RB > PB (one sided t-test) -1.542 0.053*

Panel B

Analysts' forecast € 45 million t-statistics Sign.

PB (45) > non EM 40 (one sided t-test) 5.496 0.000***

RB (45) > non EM 40 (one sided t-test) 5.120 0.000***

PB (45) > RB (45) (two sided t-test) 0.448 0.655

Analysts' forecast € 35 million t-statistics Sign.

PB (35) < non EM 40 (one sided t-test) -0,274 0.393

RB (35) < non EM 40 (one sided t-test) -1.151 0.128

PB (35) > RB (35) (two sided t-test) 0.636 0.526

*,**,*** significant at the 10%, 5% and 1% level, respectively

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