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10 Tennessee CPA Journal | NOVEMBER 2007

By Alexis V. Nisbett and Aamer Sheikh, Ph.D., CPA , CBM


Accounting Scandals: Does Rules vs. Principles Matter?
Recent developments have
increased the likelihood that U.S.
regulators may permit the use of
International Financial Reporting
Standards (IFRS) as well as (or perhaps
in place of) Generally Accepted
Accounting Principles (U.S. GAAP)
in the near future. On April 24, the
Securities and Exchange Commission
(SEC) announced that it will consider
allowing domestic companies to choose
which type of accounting standards
to follow in reporting their nancial
performance.
1
In addition, President
Bush signed an agreement with the
European Union on April 30 that will
seek to ensure conditions for the
U.S. Generally Accepted Accounting
Principles and International Financial
Reporting Standards to be recognized
in both jurisdictions without the need
for reconciliation by 2009 or possibly
sooner.
2
According to a recent
article in The Wall Street Journal, this
agreement could provide the motivation
for American companies to drop U.S.
GAAP for IFRS since the IFRS are
widely viewed as being more exible or
principles-based whereas U.S. GAAP
are often viewed to be more rigid or
rules-based.
3
This study compares rules-based
versus principles-based accounting
standards across eight countries that
reported accounting scandals to see
if any association exists between the
type of accounting standards and the
incidence of corporate and accounting
fraud.
RULES-BASED GAAP VERSUS
PRINCIPLES-BASED GAAP
IFRS are widely regarded to be
more principles-based than U.S. GAAP.
These principles-based accounting
standards emphasize the spirit of
the accounting rules rather than
strict adherence to a set of written
requirements. Mano, Mouritsen
and Pace describe an April 2003
advertisement by the accounting rm
PricewaterhouseCoopers in The Wall
Street Journal where the rm claimed
that:
Rules-based systems encourage
creativity (and not the good kind) in
nancial reporting. They allow some to
stretch the limits of what is permissible
under the law, even though it may
not be ethically or morally acceptable.
A principles-based system requires
companies to report and auditors to
audit the substance or business purpose
of transactions; not merely whether
they can qualify as acceptable under
incredibly detailed or overly technical
rules A rules-based system allows
managers to ignore the substance and,
instead ask, Where in the rules does it
say I cant do this?
4

More recently, Benston, Bromwich,
Litan and Wagenhofer point out that:
the rules-based U.S. accounting
standards have been blamed for
allowing and even encouraging
opportunistic managers to structure
transactions to produce misleading
nancial statements that their IPAs
[Independent Public Accountants]
would have to or could attest did fairly
present the nancial conditions of the
corporation in accordance with generally
accepted accounting principles. In
particular, with respect to Enron, the
audit rm Arthur Andersen was charged
with designing nancial instruments
that met the technical requirements of
GAAP while violating the intent. Public
disclosure of Enrons procedures has
given rise to a renewed debate over
whether accounting standards should be
based on rules or principles.
5

However, as Katherine Schipper,
a former member of the Financial
Accounting Standards Board (FASB)
points out, it is not that U.S. GAAP
are not based on any principles, but
rather that U.S. GAAP contain certain
elements like detailed implementation
guidance that makes them appear rules-
based. In practice, one may argue that
the detailed implementation guidance
fosters an alleged current check-
the-box or compliance mentality to
nancial reporting that reduces the
role of professional judgment in the
application of the reporting rules.
6
As a
result, opponents of U.S. GAAP suggest
that moving to a more principles-based
system is desirable, because such a
system would encourage greater exercise
of professional judgment by accountants
and auditors.
COUNTRIES REPORTING
ACCOUNTING SCANDALS
Starting with the list of 30 countries
used by the Ding, Hope, Jeanjean and
Stolowy (2007) study, we then cross-
checked this list of 30 countries to
the IAS Plus Web site, maintained by
Deloitte, which provides comprehensive
information about international nancial
reporting.
7
More specically, this Web
site summarizes the use of IFRS as
the primary GAAP for reporting by
domestic companies by country and
region (available at www.iasplus.com/
country/useias.htm). Based on this table,
20 countries are classied as following
IFRS, the United States as the only
country that follows U.S. GAAP and
the remaining nine countries (Canada,
India, Indonesia, Japan, Republic of
Korea, Malaysia, Pakistan, Thailand and
Taiwan) as following neither IFRS nor
U.S. GAAP.
Only eight countries report
accounting scandals during the
2001-2005 period. These include the
United States, that follows rules-based
accounting standards, and seven
countries which follow the more
principles-based IFRS: Australia,
France, Ireland, Italy, the Netherlands,
Switzerland and the United Kingdom.
Thus, 13 countries which follow IFRS but
did not report any accounting scandal
during this period are excluded: Austria,
Belgium, Denmark, Germany, Greece,
Hong Kong, Norway, Philippines,
Portugal, Singapore, South Africa, Spain
and Sweden. Figure 1 describes the
classications of the remaining eight
countries.
In order to ensure that only
scandals that were caused by an
accounting irregularity (like overstating
revenue by recording ctitious sales)
rather than scandals caused by other
reasons (for example, insider trading) are
included, we identify the source of the
accounting irregularities for each of the
companies by utilizing various databases
including Lexis-Nexis, ProQuest,
Stanford Law Schools Securities Class
Action Clearinghouse (available at
securities.stanford.edu) and the SECs
Accounting and Auditing Enforcement
Releases (AAERs). For each corporate
scandal identied, information relating
Tennessee CPA Journal | NOVEMBER 2007 11
to the main business sector in which the
company operated and the year in which
the scandal became public knowledge is
obtained.
INCIDENCE OF ACCOUNTING
SCANDALS DURING
2001-2005
Table 1 (see page 12) lists each of
the corporate accounting scandals and
whether they occurred under rules-based
U.S. GAAP or the more principles-based
IFRS.
During the ve-year period 2001 to
2005, accounting scandals at 38 companies
became public knowledge under the U.S.
rules-based GAAP system as compared
to only 12 companies under the more
principles-based IFRS system. Thus,
during the period 2001 to 2005, more than
three times as many accounting scandals
were reported in the United States than
in principles-based jurisdictions. This
result holds, even if we consider the total
number of publicly-listed corporations in
these eight countries.
There are approximately 6,811
companies publicly listed in the United
States versus approximately 6,892
companies listed in the seven principles-
based countries. During the period 2001-
2005, 38 out of approximately 6,811, or
0.56 percent, of listed companies reported
instances of nancial misreporting in
the United States, while only 12 out of
approximately 6,892, or 0.17 percent,
of listed companies reported instances
of nancial misreporting in the seven
principles-based countries. All other
things being equal, this suggests that a
higher incidence of corporate accounting
fraud occured inside the United States as
compared to outside the United States.
The magnitude of the accounting
scandal was sufcient to trigger lings
for Chapter 11 bankruptcy at 12 of the 38
companies (or 31.6 percent) following U.S.
GAAP, namely, Adelphia, Ashford.com,
Delphi, Enron, Homestore.com, Liberate
Technologies, Mirant, NextCard, Peregrine
Systems, Refco, Teltran International and
WorldCom. Global Crossing also went
bankrupt, but it was the deterioration of its
underlying business
rather than nancial
misreporting that
was the primary
cause.
8
The nancial
misreporting was
typically caused by
improper revenue
recognition and/or improper expense
recognition.
The magnitude of the scandals at
three companies (or 25 percent) using
principles-based standards, namely,
HIH Insurance, Parmalat and Cirio
Finanziaria, was sufcient to trigger
bankruptcy proceedings. The nature of
the misreporting was rather dispersed,
including improper revenue recognition,
improper expense recognition, improper
accounting in connection with business
combinations and direct violations of
accounting principles. Additionally,
the role of American inuence was
evident in two of the 12 companies
(Royal Ahold and Alstom). Not only did
these two companies have U.S. stock
exchange listings, but their accounting
problems originated with their American
subsidiaries.
9
Thus, it appears that the
magnitude of the misreporting triggered
a relatively higher number of bankruptcy
lings under U.S. GAAP as compared to
IFRS.
Prior research also suggests that lax
enforcement of IFRS may result in limited
compliance with IFRS, thereby limiting
their effectiveness.
10
One wonders whether
the lower number of reported accounting
scandals under the seven principles-
based (international) regimes is partially
due to looser enforcement of accounting
standards in countries outside the United
States.
CONCLUSION
The results of the study show a
higher incidence of corporate accounting
fraud occurs in rules-based United States
as compared to the more principles-
based countries. However, variation in
enforcement levels and other cross-country
differences like legal environment and
corporate governance structure may bear
on the quality of information produced by
nancial reporting conventions in different
countries.
11
It is possible that a lower
number of accounting scandals have been
reported in IFRS countries due to these
cross-jurisdictional differences. Even so,
the results of this study raise the question
of whether the use of more principles-
based accounting standards would lead to
a lower incidence of nancial misreporting
in the United States. n
Endnotes
1. Securities and Exchange Commission. SEC
announces next steps relating to International
Financial Reporting Standards. April 24, 2007.
www.sec.gov/news/press/2007/2007-72.htm.
2. The White House. Framework for advancing
transatlantic economic integration. April
30, 2007. www.whitehouse.gov/news/
releases/2007/04/20070430-4.html.
3. Reilly, D. Whats better in accounting, rules or
feel? The Wall Street Journal. April 30, 2007
pp. C1.
4. Mano, R., Mouritsen, M., and Pace, R.
Principles-Based Accounting: Its not new, its not
the rule, its the law. The CPA Journal, Vol. 76
(2006) pp. 60-63.
5. Benston, G., Bromwich, M., Litan, R., and
Wagenhofer, A. Worldwide Financial Reporting: The
development and future of accounting standards.
Oxford University Press. (New York, NY, 2006).
6. Schipper, K. Principles-Based Accounting
standards. Accounting Horizons, Volume 17
(2003) pp. 61-72.
7. Ding, Y., Hope, O., JeanJean, T., and Stolowy,
H. Differences between domestic accounting
standards and IAS: Measurement, determinants and
implications. Journal of Accounting and Public
Policy, Vol. 26 (2007) pp. 1-38.
8. Grant, R., and Visconti, M. The strategic
background to corporate accounting scandals.
Long Range Planning Journal, Vol. 39 (2006) pp.
361-383.
9. Ibid
10. Ball, R., Kothari, S., and Robin, A. The effect
of international institutional factors on properties of
accounting earnings. Journal of Accounting and
Economics, Vol. 29 (2000) pp. 1-51.
11. Ruland, W., Shon, J., and Zhou, P. Effective
controls for research in international accounting.
Journal of Accounting and Public Policy, Vol. 26
(2007) pp. 96-116.
About the Authors:
Alexis V. Nisbett is a graduate student at Quinnipiac
University. She can be reached at alexis.nisbett@
quinnipiac.edu. Aamer Sheikh, Ph.D., CPA, CBM
is an assistant professor of accounting at Quinnipiac
University. He can be reached at aamer.sheikh@
quinnipiac.edu.
Figure 1: Countries Reporting Accounting
During the Period 2001 - 2005
Rules-Based GAAP Principles-Based GAAP (or IFRS)
United States
Australia, France, Ireland, Italy,
Netherlands, Switzerland, United Kingdom
See table on page 12
12 Tennessee CPA Journal | NOVEMBER 2007
Rules-Based GAAP
Company Main Business Year
United States
Adelphia Cable & Telecom Services 2002
AIG Insurance & Financial Services 2004
AOL Time Warner Media 2002
Ashford.com Retail Services 2001
Bristol-Myers Squibb Pharmaceuticals 2002
Broadcom Semiconductors 2001
CMS Energy Gas & Power 2002
Computer Associates IT Management Software 2002
Critical Path Business Services 2001
Delphi Electronics & Transportation 2004
Duke Energy Gas & Power 2002
Dynegy Oil & Gas 2002
El Paso Corporation Gas & Power 2002
Enron Gas & Power 2001
Exxon Energy & Petrochemical 2001
Fannie Mae Mortgage Financing 2004
Freddie Mac Mortgage Financing 2003
Global Crossing Telecommunications 2002
Halliburton Technical services, Construction 2002
Healthsouth Healthcare 2002
Homestore.com Real Estate 2002
Kmart Discount Retail 2002
Liberate Technologies Software 2002
Lucent Technologies Telecommunications 2002
Merck Pharmaceuticals 2002
Mirant Electricity Production 2002
NextCard Consumer Financial Services 2001
Niccor Energy Gas & Power 2002
Peregrine Systems Software 2002
PNC Financial Financial Services 2002
Qwest Telecommunications 2002
Refco Investment Services 2005
Reliant Energy Gas & Power 2002
Sunbeam Electronics, Home Appliances 2001
Tribune Company Media and Newspapers 2004
Teltran International Telecommunications 2001
WorldCom Telecommunications 2001
Xerox Ofce Equipment 2002
Principles-Based GAAP (IFRS)
Company Main Business Year
Australia
HIH Insurance Insurance 2001
France
Vivendi Universal Media & Telecommunications 2002
Alstom Engineering 2003
Ireland
Elan Pharmaceuticals 2001
Italy
Parmalat Food Processing 2003
Cirio Finanziaria Food Processing 2002
Skandia Financial Services 2003
Netherlands
Royal Ahold Retail 2003
Royal Dutch Shell Energy & Petrochemical 2004
Switzerland
Adecco Human Resource Solutions 2004
Panalpina Logistics 2005
United Kingdom
Ashtead Group Construction Equipment Rental 2003
Table 1: Rules-Based vs. Principles-Based Accounting Standards & the Incidence of
Corporate Financial Misreporting During the Period 2001 - 2005