Explaining Rules‐Based Characteristics in U.S. GAAP: Theories and Evidence

• Author: DAIN C. DONELSON,RICHARD D. MERGENTHALER,JOHN MCINNIS
• Date: 01 June 2016
• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/1475-679X.12112

DOI: 10.1111/1475-679X.12112

Journal of Accounting Research

Vol. 54 No. 3 June 2016

Printed in U.S.A.

Explaining Rules-Based

Characteristics in U.S. GAAP:

Theories and Evidence

DAIN C. DONELSON,

∗JOHN MCINNIS,

∗

AND RICHARD D. MERGENTHALER

†

Received 2 June 2014; accepted 4 February 2016

ABSTRACT

Despite debate on the desirability of rules-based standards, no studies provide

evidence on why accounting standards take on rules-based characteristics. We

identify and test five theories from prior research (litigation risk, constraining

opportunism, complexity, transaction frequency, and age) that could explain

why some U.S. accounting standards contain rules-based characteristics. Liti-

gation risk and complexity are most consistently related to cross-sectional and

time-series variation in rules-based characteristics. We find more limited evi-

dence that frequent transactions, age, and desires by regulators to constrain

opportunistic reporting are related to rules-based standards. We note, how-

ever, that our findings are necessarily descriptive because standards arise en-

dogenously from market and political forces, limiting causal interpretation.

Further, it is difficult to perfectly separate rules-based characteristics of the

∗University of Texas at Austin; †University of Iowa.

Accepted by Douglas Skinner. We are grateful to two anonymous referees, Abigail Allen,

Rich Frankel, Justin Hopkins, Ray Pfeiffer,Katherine Schipper, Dan Taylor,and workshop par-

ticipants at the BYU Research Symposium, the University of Connecticut, the University of

Iowa, the University of Texas,Texas Christian University, Washington University,the FEA con-

ference, and the NASD OMX Conference on Capital Markets at the University of Texas at

Austin for their thoughtful feedback and insights. We also thank the University of Iowa and

the University of Texasat Austin for research support. Finally, we thank Jeanmarie Lord for re-

search assistance. An Internet Appendix to this paper can be downloaded at http://research.

chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

827

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

828 D.C.DONELSON,J.MCINNIS,AND R.D.MERGENTHALER

standard from both the complexity of the standard and the characteristics of

the underlying transaction, including the complexity of the transaction.

JEL codes: M40; M41; M48; K20; K22

Keywords: rules-based accounting standards; standard setting; litigation;

transaction complexity

1. Introduction

Why do accounting standards become rules-based? While there are differ-

ent ways to define “rules-based standards,” including (1) standards with a

simple treatment requiring little discretion and (2) standards that seem ar-

bitrary, we focus on (3) standards that take on “rules-based characteristics”

such as the presence of bright lines, scope exceptions, volumes of inter-

pretive guidance, and excessive detail. While we cannot perfectly separate

these definitions, we focus on (3) because it is amenable to objective mea-

surement and is commonly used by regulators, standard setters, and aca-

demics in the debate over rules-based standards (e.g., FASB [2002], Nelson

[2003], SEC [2003]). These “rules-based” characteristics are intended to

provide greater specificity and clarity on accounting for particular transac-

tions. Critics, however, contend that these characteristics increase the com-

plexity of accounting standards, decrease the use of professional judgment,

and encourage transaction structuring (see SEC [2003]).

Toexplain why the accounting system is the way it is, we exploit the signif-

icant variation, both over time and across areas of U.S. GAAP, in the extent

to which standards contain rules-based characteristics. Explaining this vari-

ation is important in advancing the accounting literature and informing

policy debates, such as whether U.S. GAAP should converge with Interna-

tional Financial Reporting Standards (IFRS) or, otherwise, move to more

principles-based standards. If factors inherent in the U.S. business, regula-

tory or legal environment (e.g., the presence of complex transactions or

high litigation risk) explain the presence of rules-based characteristics in

accounting standards, then standards will likely exhibit these characteris-

tics under any standard-setting regime (see Watts [2006]).

The standard-setting process is influenced by economic, political, and

regulatory factors (Watts [2006]). We, therefore, draw on the accounting

literature and the law and economics literature to identify theories that

could explain variation in rules-based characteristics in U.S. GAAP. The

primary sources in the accounting literature are positive accounting theory

(e.g., Watts and Zimmerman [1978]), the political economy of standard

setting (e.g., Ramanna [2010]), and the rules-versus-principles literature

(e.g., Schipper [2003]). This literature views standard setting as a politi-

cal process that balances the interests of preparers, auditors, regulators,

and standards setters (Watts [2006]). The law and economics literature on

rule-making observes that detailed rules are costly to write and are socially

desirable when their benefits exceed their costs (e.g., Ehrlich and Posner

EXPLAINING RULES-BASED CHARACTERISTICS IN U.S.GAAP 829

[1974], Diver [1983]). Five distinct theories emerge from these literatures,

which we group into two broad categories: enforcement and efficiency.

The first two theories relate to enforcement. The first theory is litigation

risk, which posits that managers and auditors seek to minimize costs in-

curred in private securities litigation and public SEC enforcement. Under

this theory, rules-based standards provide clear guidance and “safe harbors”

from litigation or suspected wrongdoing (Schipper [2003]). Thus, this the-

ory predicts a positive relation between litigation risk and rules-based char-

acteristics.

The second theory, constraining opportunism, also involves enforcement

from the perspective of regulators and standard setters (see Ball [2009]).

Regulators and standard setters have asymmetric loss functions and thus

want to avoid scandals (Watts [2003]). Detailed rules aid enforcement by

clearly defining acceptable behavior (Ehrlich and Posner [1974]). Alter-

natively, rules-based standards encourage transaction structuring to evade

certain treatments, implying that regulators may prefer principles-based

standards to discourage opportunism (Nelson, Elliott, and Tarpley[2002]).

Thus, unlike the litigation theory, the constraining opportunism theory of-

fers no clear directional prediction.

The remaining three theories deal with efficiency gains. The third the-

ory is complexity, which argues that it is more efficient for complex mea-

surement areas and complex transactions to have rules-based standards.

Complex issues require significant and numerous judgments on the appro-

priate accounting treatment, which consumes time and other resources for

preparers, auditors, regulators, and standard setters. Since managers want

to minimize preparation and audit costs (Watts and Zimmerman [1978]),

and rule-makers want to minimize the frequency and cost of inquiries and

dispute resolution (Ehrlich and Posner [1974]), measurement complexity

and transaction complexity lead to more guidance. This theory predicts

a positive relation between different forms of complexity and rules-based

characteristics.

The fourth theory is transaction frequency, which contends that it is

more socially efficient to have rules-based standards for frequent or com-

mon transactions. The basic intuition is that it is costly for constituents to

continually reinvent the wheel when considering how to account for fre-

quent transactions (Diver [1983], Kothari, Ramanna, and Skinner [2010]).

This theory predicts a positive relation between frequent transactions and

rules-based characteristics.

The fifth and final theory is age, which posits that standards become

more rules-based as they age. Several studies argue that issues become more

understood as they age, and it is, therefore, more efficient to write de-

tailed rules to adjudicate disputes or enforce contracts related to mature

issues (e.g., Ehrlich and Posner [1974], Schlag [1985], Ellison and Holden

[2014]). It is unclear whether this theory is simply a natural manifestation

of the theories discussed above (e.g., age leads to more time for enforce-

ment activities or added transaction complexities in an area). However, we