Transparency in financial reporting: a look at rules-based versus principles-based standards.

Phillips, Thomas J., Jr. ; Drake, Andrea ; Luehlfing, Michael S. 等

INTRODUCTION

Transparency in financial reporting has always been considered positive from the standpoint of financial statement users, but not necessarily something for which management has striven. Rather, corporate managers often envision a major part of their role as "marketing" the company, particularly in regard to raising capital and maintaining equity growth. Management can even seem obsessed with painting the company in "a good light."

Such an obsession by management has many times led to unwarranted surprises for external users of financial statements. This is especially problematic when companies report high-dollar earnings and substantial market share growth one moment only to file for bankruptcy in the next moment. No doubt, dubious information reported by management immediately preceding such bankruptcies were anything but transparent to financial statement users.

To gain insights into such lapses in transparency, we first discuss a seemingly innocent but often deceptive practice--pro-forma reporting. Thereafter, we provide some thoughts regarding financial reporting under U.S. Generally Accepted Accounting Principles (GAAP) as well as International Financial Reporting Standards (IFRS). Next, we draw parallels between the coming adoption of IFRS and past pro forma reporting controversies. Lastly, we follow our theoretical discussions with a study of student subjects where we address their perceptions regarding whether rules-based versus principles-based accounting standards would be preferable to different external stakeholders.

PRO FORMA REPORTING

Pro forma reporting has historically been considered a means to facilitate the comparison of "apples with apples" or a means to "right a wrong" with respect to the disclosure of transactions and events which, without special treatment, might mislead investors and other stakeholders. Derived from a Latin phrase with the connotation "as if," pro forma information has traditionally been associated with reporting infrequent events such as a change in accounting principle, a change in normal operations or change in the entity (e.g., when one company acquires another company). In such instances, pro forma information assists financial statement users by illustrating the financial position, results of operations, and/or cash flows had certain transactions or events not occurred, occurred earlier, or occurred differently. Financial analysts and other financial statement users desire maximum "visibility" in order to estimate future company earnings.

At best, pro forma information cuts through some of the fog and haziness caused by one-time transactions and events, such as the expansion of a new product line or the elimination of a weak segment. At worst, pro forma reporting misleads financial statement users through somewhat dubious one-time charges or credits related to events that have not occurred and may never occur. For example, one company reported pro forma amounts including a large gain on sale of a subsidiary, while excluding an even larger expense for the amortization of purchased intangibles and other items such as research and development charges. Similarly, another company reported a multibillion dollar pro forma net income (after selectively excluding various charges), while the actual net loss for the year exceeded one billion.

In certain situations the desire to undertake aggressive pro forma practices may appear justifiable to some degree. For example, managers argue that there are deficiencies in GAAP such as unrecorded assets like certain patents, trademarks, copyrights, trade secrets, and human resources. Additionally, managers also bemoan the silence of GAAP regarding non-financial factors such as product development efficiency, customer satisfaction, market share, and many other similar measures. Admittedly, while some companies may have legitimate arguments regarding such deficiencies, others simply want to trim bad numbers from their financial statements. Such a selective slicing and dicing of negative amounts may "numerically" meet Wall Street expectations, but it does not meet the "spirit" of Wall Street expectations and, as a consequence, results in a loss of credibility. Of course, inappropriate pro forma practices may merely represent the manifestation of management's frustration with slumping stock prices-and disappearing bonuses. In response to these and other concerns, the Financial Accounting Standards Board (FASB) became involved in a project that encompasses issues relating to the appropriateness of pro forma practices within the broader context of financial performance measures.

FASB's PROJECT ON REPORTING FINANCIAL PERFORMANCE

Several years ago, FASB became engaged in a project entitled Reporting Information About the Financial Performance of Business Enterprises: Focusing on the Form and Content of Financial Statements (FASB, 2001). Understandably, the issue of reporting on financial performance is of major significance and is much broader than simply an examination of pro forma reporting abuses found in some earnings releases. FASB's project attempted to offer standard definitions for some commonly used terms. For example, Senior FASB Project Manager Ronald J. Bossio, CPA indicates that with respect to the "EBITDA" (earnings before interest, taxes, depreciation, and amortization) calculation, a manufacturing firm may or may not include depreciation in its production costs (and thus, cost of goods sold). Additionally, he indicates that a common definition sponsored by FASB would make it difficult for companies to use their own variation.

Generally speaking, FASB's project was undertaken to respond to the following threats to financial statement transparency:

* No common definitions of the elements of financial performance and inconsistent practices regarding the presentation of financial performance,

* Increased pro forma reporting and other evidence suggesting that the use of and reliance on net income as an indicator of performance is decreasing, and

* No consensus or common definitions for the key financial measures or indicators of financial performance that financial statements or financial reporting should provide.

Table 1 specifies the major questions asked by FASB concerning financial statement transparency. The primary focus of these questions concerned what financial measures are being used by investors, creditors, analysts and others. Additionally, the FASB also considered whether changes to existing standards are needed to require the display of line items to support the presentation of new financial measures. Further, the FASB attempted coordination with the International Accounting Standards Board (IASB) and the UK's Accounting Standards Board (ASB), seeing a great benefit of sharing information given that the IASB and the ASB added a similar focus to their agendas. Hence, FASB asked their staff to use IASB and ASB papers as a basis of FASB discussions.

FASB's research initially centered on interviewing investors, creditors, and their advisors to obtain opinions concerning key financial measures. Preliminary findings from the interview process were as follows:

* Users have a strong interest in greater disclosure of information with predictive value.

* There is no widespread dissatisfaction with or demand for sweeping change in financial statement display; that is, there is no need to scrap any particular financial statement, add new financial statements, or make other extreme changes in display.

* Key financial measures include the following, which are not necessarily well-defined terms or notions: (a) "operating" free cash flow or free cash flow, (b) return on invested capital, and (c) "adjusted," "normalized," or "operating" earnings.

* Net income is an important measure that often is used as a starting point for analysis but generally is not the most important measure used in assessing the performance of an enterprise or in assessing its prospects relative to other enterprises in its industry.

* There is little demand for or opposition to the presentation of comprehensive income in a single statement provided that the individual items of comprehensive income are transparent--that is, their amounts are clearly labeled and disclosed.

* Many, if not most, users prefer a statement of cash flows that reports operating cash flows under the direct method--that is, clearly discloses amounts for items such as cash paid to suppliers and employees and cash collected from customers.

* Users also have a strong interest in greater disclosure about the major components of an enterprise's capital expenditures that might provide forward-looking information about an enterprise's plans and prospects (for example, amounts of cash outflows for purchases of productive assets to maintain existing capacity and to expand capacity).

While the FASB expressed a specific concern regarding the increased use of alternative, non-GAAP measures of performance such as EBITDA, the Board had a broader concern in that financial statement users seemed willing to follow management's lead and focus on these somewhat ill-defined, non-GAAP measures. Given that this highly-summarized and selective form of reporting permeated the financial marketplace, FASB wanted to ensure the future relevance of financial reporting by taking an open-minded, closer look at GAAP. Subsequently, FASB joined with the IASB in order to facilitate the convergence of standards; their efforts became a broader project currently called "Financial Statement Presentation-Joint Project of the IASB and FASB" (FASB, 2009).

DISCLOSING NON-GAAP MEASURES

Whether included in the supplemental information accompanying the financial statements or included in the pro forma amounts announced in press releases, non-GAAP measures may enhance as well as impair financial statement transparency. Unfortunately, history suggests the latter rather than the former. As early as 1973, the SEC highlighted problems associated with presentations of non-GAAP measures in Accounting Series Release (ASR) No. 142 Cautionary Advice Regarding the Use of "Pro Forma" Financial Information (SEC, 1973). At that time, the Commission warned about potential confusion when using non-GAAP measures stating:

 ... If accounting net income computed in conformity with generally
 accepted accounting principles is not an accurate reflection of
 economic performance for a company or industry, it is not an
 appropriate solution to have each company independently decide what
 the best measure of its performance should be and present that
 figure to its shareholders as Truth.

More recently, the SEC provided staff recommendations in the Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance (SEC 2001) that addressed pro forma reporting. Even so, pro forma abuses continued to surface and additional attention on financial reporting was necessary.

Fortunately, the Sarbanes-Oxley Act of 2002 was signed into law with provisions that specifically address pro forma reporting. Section 401 (b) of the Act directed the SEC to adopt rules requiring public disclosure (e.g., earnings releases) such that it does not contain material untrue statements of fact or omit statements that are necessary to avoid misleading the public through non-GAAP financial measures. Additionally, under Section 401(b), publicly held companies were required to not only reconcile any non-GAAP financial measures with the comparable GAAP financial measures, but to disclose the reconciliation in the press release.

Empowered by Section 401 (b) of Sarbanes-Oxley, the SEC adopted new disclosure requirements under Regulation G and made amendments to Item 10 of Regulation S-B and Item 10 of Regulation S-K. Regulation G requires companies making public disclosures or releases of non-GAAP financial measures to include:

* a presentation of the most directly comparable GAAP financial measure; and

* a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.

Amendments to Item 10 of Regulations S-B and S-K apply to financial measures in filings with the SEC, and under an additional amendment to Form 8-K, public releases became part of the required SEC filings. Companies are required to file such information on Form 8-K within two days of the earnings release or similar public disclosure. Hence, the amendments to Regulations S-B and S-K apply to the earnings releases of public companies and restrict how non-GAAP pro forma amounts are presented. These amendments require registrants using non-GAAP measures to provide:

* a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP;

* a reconciliation ... which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, or the differences between the non-GAAP financial measure disclosed or released with the most directly comparable financial measure or measures calculated and presented in accordance with GAAP;

* a statement disclosing the reasons why the registrant's management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant's financial condition and results of operations; and

* to the extent material, a statement disclosing the additional purposes, if any, for which the registrant's management uses the non-GAAP financial measure that are not otherwise disclosed.

According to the SEC, these amendments prohibited:

* excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than the measures EBIT and EBITDA;

* adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or (2) there was a similar charge or gain within the prior two years;

* presenting non-GAAP financial measures on the face of the registrant's financial statements prepared in accordance with GAAP or in the accompanying notes;

* presenting non-GAAP financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; and

* using titles or descriptions or non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.

In addition to the Sarbanes-Oxley (Section 401(b)) requirements and the resulting SEC regulations (Regulation G and Item 10 of Regulations S-B and S-K), the Financial Executives International (www.fei.org) and the National Investor Relations Institute (www.niri.org) provide guidance regarding pro forma reporting. Each organization maintains that GAAP information provides a "critical framework" for pro forma results. They also stress the need for reconciliation between pro forma and GAAP results (as required by Regulation G). Further guidance regarding pro forma reporting is found in Standard & Poor's whitepaper, "Measures of Corporate Earnings" (www.standardandpoors.com). The whitepaper discusses S&P's measure of operating earnings, deemed "core earnings."

Quality, transparent reporting should be the goal of all companies and is certainly essential for financial reporting to regain and maintain credibility. Still, the financial marketplace continues to use key financial performance data that are yet to be standardized. Some have voiced legitimate concerns that not every company has the same reporting needs and that a certain amount of flexibility is needed. Nonetheless, as seen from the market's reaction to questionable accounting practices, caution is essential. Until some consensus is reached regarding key performance indicators and these measures gain approval, SEC requirements have limited the manner in which companies disclose non-GAAP performance measures in pro forma reporting. It is prudent for companies to refrain from too much selective reporting-especially what former Chief SEC Accountant Lynn Turner refers to as "EBS" reporting ("Everything but Bad Stuff).

RULES-BASED VERSUS PRINCIPLES-BASED ACCOUNTING STANDARDS: PAST IS PROLOGUE?

Problems faced earlier regarding pro forma reporting may have been largely resolved, but the sentiment of managers has not really changed, as seen when we look at the more recent past. The statement that there is "nothing new under the sun" could not be more appropriate than when considering today's economic crisis, corporate practices such as questionable revenue recognition, and how the convergence of standards-setting will impact financial reporting, perhaps setting the stage for a new approach to the same old fog and haziness that leaves little trace of transparency.

Questions now focus on FASB versus IASB standards. While each Board has issued its share of rules-based standards, it is generally agreed that FASB's previous standards are more aptly described as "rules-based" and IASB's standards tend to be closer to "principles-based." At first blush, the complexities of rules-based standards make principles-based standards seem quite attractive especially in situations where rules-based standards force companies with unusual circumstances to do a poor job of reporting true economic substance. On the other hand, given the flexibility inherent in principles-based standards, such standards may provide opportunities for some managers to reduce financial statement transparency.

One concern with recent changes is what sometimes seems to be a failure to consider the historical development of previous standards. For example, provisions under recently enacted SFAS No. 154, Accounting Changes and Error Corrections (FASB, 2005) routes the cumulative effect of changes in accounting principles through the statement of retained earnings. While it is true that the cumulative effect of a change does not really affect this year's earnings, the reason that Accounting Principles Board (APB) Opinion No. 20 Accounting Changes (APB, 1971) forced companies to place the cumulative effect of changes on the face of the income statement in the year of change was to "red flag" the change in a manner that it would not go unnoticed (or to keep the cumulative effect from "escaping" the income statement). Prior to APB No. 20, some companies had a habit of slipping changes in accounting principles onto the statement of retained earnings as a prior period adjustment, thereby, never actually showing the effect of the change on income. Such changes usually occurred at a time when the change was financially beneficial to the company's earnings (see May and Schneider, 1988) Now, under SFAS No. 154, the prior period adjustment is referred to as a retrospective application, but the effect is essentially the same. While previously released financial statements must now be restated under the SFAS No. 154, under APB No. 20 this was considered a poor way to disclose a consistency violation except in special cases. Thus the standard-setting process concerning accounting changes has gone full circle. Perhaps more importantly, is this situation an isolated instance or a foreshadowing of things to come?

While SFAS No. 154 will undoubtedly have some benefits, one must question whether this is an overall improvement. Will companies today not take advantage of a situation that was previously considered a problem? What current guarantees will ensure that companies do not use the new standard as an open avenue to managing earnings? One needs only to look back at recent revenue recognition abuses (e.g. channel stuffing) to understand the lack of integrity of some corporate managers. Abuse of the general principle of revenue recognition led FASB to make rules that would disallow certain practices. This, in turn, led to additional rules to close new loopholes. In other words, a rules-based system is sometimes a natural progression from a principles-based system, particularly when there is a lack of integrity among those responsible for the financial statement transparency of a company, To gain insights into this matter, we conduct a study of student subjects where we address their perceptions regarding whether rules-based versus principles-based accounting standards would be preferable to different external stakeholders.

HYPOTHESES

There are several reasons to believe that corporate managers would prefer principles-based standards over rules-based standards. First, if managers in good faith want to report what they believe to be the financial consequences of longer term transactions or activities, a principles-based standard would allow them the flexibility to do so. Second, if managers believe there are benefits to smoothing earnings or meeting analyst forecasts, the flexibility of principles-based standards will, again, allow them to more easily accomplish these goals. Thirdly, if management compensation is linked to meeting various goals, principles-based standards would seem to facilitate the attainment of these goals--whether in the best interest of the firm or not. Given these arguments, we predict that those familiar with the accounting environment would believe that managers would prefer principles-based standards over rules-based standards.

Hypothesis 1: Corporate managers will be perceived to prefer principles based standards over rules-based standards.

Investors and potential investors, with the goal of making economically rational resource allocations, would ideally prefer the information contained within a firm's financial statements to be without error or bias, and to facilitate comparisons with other firms. Their interest is in trying to predict the future value of a current or potential equity investment in order to maximize their return on their equity investments. Rules-based standards constrict management's choices of how to report certain activities, thereby potentially hampering an investor's efforts to value a firm if the rules preclude the firm from reporting the "true" effect of a given activity. However, a principles-based system, while allowing for the flexibility to report "truthfully" an event that a rules-based system might have "misreported," also allows for earnings manipulation that might not be "truthful" (i.e. the management of earnings strictly to increase compensation). Significantly, a rules-based system ensures (more often than not) that two firms will report a given event in the same way, allowing for easier comparability. Given this and the potential downside associated with the flexibility of a principles-based system, we predict that investors will be perceived to prefer rules-based systems.

Hypothesis 2: Investors will be perceived to prefer rules-based standards over principles-based standards.

Creditors are necessarily interested in assessing a firm's ability to repay debt obligations with a fixed rate or amount of interest. There is no residual interest in the long-term value of the firm, other than in determining its ability to pay long-term debt. Given that creditors have a more limited need to assess the value of a firm (i.e., its ability to make fixed principal and interest payments versus trying to determine the potential for investment income) we predict that rules-based standards would be perceived to be their preference.

Hypothesis 3: Creditors will be perceived to prefer rules-based standards over principles-based standards.

Accounting students who have progressed to the junior level and above are likely to be aware of the need for GAAP to satisfy the information needs of various stakeholders (i.e., financial statement users). Through course work, job/internship experience, and familiarity with the convergence between U.S. GAAP and IFRS, they have also been exposed to the conflicting views of various stakeholders with respect to rules-based and principles-based standards. In this knowledge environment, we believe accounting students will be aware of the need for a wide variety of standards that may include both rules-based and principles-based standards. Thus, we believe students will be neutral with respect to whether they personally believe rules-based or principles-based standards to be preferable. In addition, they are likely to believe that an eventual comprehensive set of standards will contain both types.

Hypothesis 4: Upper level accounting students will be neutral with respect to whether they perceive rules-based or principles-based standards to be preferable.

Hypothesis 5: Upper level accounting students will agree that a mix of rules-based and principles-based standards are likely.

RESEARCH METHOD

To obtain evidence concerning the above hypotheses, we asked student subjects to read two examples of current accounting standards combined with short explanatory notes as shown in the Appendix. One example was based on Accounting Research Bulletin (ARB) No. 43, Restatement and Revision of Accounting Research Bulletins (Committee on Accounting Procedure, 1953) that contains the general guidance for when it is appropriate to recognize revenue. Also contained in the example is reference to SFAS No. 48, Recognition of Revenue when Right of Return Exists (FASB, 1981). Thus, the scenario provides both the general principle of when it is appropriate to recognize revenue and specific "rules" to apply in a situation where correct reporting under only a "principle" may be difficult to determine (i.e., if the right of return exists).

The second example is based on SFAS No. 2, Research and Development (FASB, 1973). This scenario basically explains the rule for recording all research and development (R&D) costs as expenses, but raises the issue of a principles-based standard that would allow for value-creating R&D to be recorded as an asset and non-value creating R&D to be expensed.

After reading each example, subjects were asked to respond to the five questions shown in Panel C of the Appendix. Three of the items asked them to take the perspective of a corporate manager, investor and creditor (respectively) and then rate the degree to which they believed rule-based versus principles-based standards were preferable. Another item asked them for their personal belief on which type of standard is better. The final item asked them whether they agreed or disagreed with the idea that standards need to be a mixture of rules-based and principles-based standards. Descriptive statistics related to these questions is shown in Table 2.

Thirty-six upper-division and master's level students were recruited to participate in the study. The age of participants ranged from 20 to 29 years of age with an average of 22.5 years. Sixty-six percent were males; 34 percent females. The majority were Undergraduate Accounting and Masters of Accounting students, with the remaining subjects primarily in the Masters of Business Administration program but with backgrounds in accounting.

Approximately half of the subjects were given the R&D example first, while the other half was given the revenue recognition example first to control for and analyze possible order effects. Overall, subjects answered the five questions consistently, regardless of the order of the scenarios. As shown in Table 3, there was a significant positive correlation between the answers given for each perspective (i.e., manager, inventor, or creditor) under the two scenarios. For example, the correlation between subject responses from the manager perspective across the two scenarios was significant (Pearson correlation = .571; p-value < .001, two-tailed). In addition, independent samples t-tests revealed no significant differences in mean responses for any question based on which order they saw the scenarios. Thus, we find no evidence of any "order" effects. In general, we also find that the type of scenario did not affect subjects' responses. The exception was the response related to a manager's perspective, described in the next paragraph. Overall, their beliefs of whether rules-based or principles-based standards did not depend on the context, but there were differences with respect to the perspective (i.e., manager, creditor, or investor) subjects were asked to take. Given the highly significant correlation between subject answers to each respective question across the two scenarios, we summed their responses as shown in the fourth column of Table 2 labeled "Sum of R&D and Revenue Recognition."

The mean summed response to the question of whether rules-based or principles-based standards would be more appropriate from a manager's perspective was 6.06, with a range of 2 to 10. Higher numbers indicate a preference for principles-based; lower numbers, rules-based. Our prediction for responses from a management perspective was that respondents would prefer principles-based standards over the rules-based standards. However, we found a degree of conflict related to responses across the two scenarios. More specifically, a higher percentage of subjects (i.e., 56 percent) responded that principles-based standards were more appropriate when faced with the R&D scenario than under the revenue recognition scenario (i.e., 39 percent). For the R&D scenario, 14 out of 36 subjects responded with a "1" or "2" (i.e., rules-based is "absolutely" or "somewhat" better than principles based standards) while 20 subjects responded with a "4" or "5" (i.e., principles-based is "somewhat" or "absolutely" better than rules based standards). In contrast, under the revenue recognition scenario, 19 out of 36 subjects responded with a "1" or "2" versus 14 that responded with a "4" or "5". This shows a tendency for subjects to believe that, from a management perspective, rules-based is somewhat better for revenue recognition while principles-based standards are somewhat better with respect to R&D. However, a paired samples t-test revealed only a modest level of significance across the scenarios (t-statistic = 1.25; p-value =.11, one-tailed).

From an investor's perspective, we predicted subjects would prefer rules-based standards. The mean summed response shown in Table 2 is 5.56 and the mode for both scenarios is "2", indicating support for the prediction that rules-based standards would be preferred. Unlike the responses for a management perspective, the majority of subjects responded that they preferred rules-based standards over principles-based standards under both scenarios (i.e., 18 versus 14 under the R&D scenario; and, 21 versus 10 under the revenue recognition scenario). A t-test of whether the summed responses were significantly lower than the midpoint of "6" revealed a modest level of significance (t-statistic = 1.19; p-value = .12, one-tailed). Given the small sample size, we conclude that the results provide modest support for the prediction that rules-based standards were preferred from an investor's perspective.

From a creditor's perspective, we also predicted subjects would prefer rules-based standards. The mean summed response shown in Table 2 is 5.08 and the mode for both scenarios is "2", indicating support for the prediction that rules-based standards would be preferred. Again, the majority of subjects responded that they preferred rules-based standards over principles-based standards under both scenarios (i.e., 21 versus 8 under the R&D scenario; and, 22 versus. 12 under the revenue recognition scenario). A t-test of whether the summed responses were significantly lower than the midpoint of "6" revealed strong support for the prediction (t-statistic = 2.46; p-value = .02, one-tailed). Thus, we conclude that from a creditor's perspective, respondents believed rules-based standards would be preferred.

With respect to subjects' personal beliefs regarding whether rules-based versus principles-based standards are preferable, we made no specific prediction, based on the idea that accounting students would be aware of the pros and cons of both types and would therefore respond that neither type is absolutely preferred to the other. Consistent with this, we predicted that subjects would agree with a proposed mixture of rules-based and principles-based standards (i.e., Question 5 in Panel C of the Appendix).

Our results are consistent with these predictions. With respect to their personal beliefs (i.e., Question 4 in Panel C of the Appendix), the summed mean response was 6.00, which is (obviously) not statistically different than the mid-point prediction of "6" which corresponds to the response that neither rules-based or principles-based standards are preferable.

The mean summed response to Question 5 in Panel C of the Appendix is 7.64, which indicates that subjects in general agreed that a mixed set of standards is needed. A one-sample t-test indicates that this value is significantly greater than the midpoint of "6" (t-statistic = 5.70; p-value <.001, one-tailed).

We also examined whether several control variables were correlated with subject responses. We found no correlation between gender, age, or taking (prior or concurrently) any particular accounting course and the responses to the five questions. However, grade point average was negatively correlated with responses to Question 2 (i.e., the investor's perspective). Thus, higher GPA students tended to believe that rules based standards would be preferable to investors.

CONCLUSION

Study results indicate perceptions that corporate managers prefer principles-based standards, while investors and creditors likely lean toward rules-based standards. When looking at the personal preferences of study participants, perceptions are more in the middle, either suggesting no real preference between the approaches or perhaps a tendency to remain undecided for now. There was an inclination for perceptions to vary between the two scenarios which may show participants are aware that different circumstances may call for different degrees of guidance. Finally, participants believe that new standards will probably garner rules-based as well as principles-based characteristics, not purely one or the other. Looking at the history of standards-setting, that assessment seems appropriate.

Rules-based or principles-based standards alone are not good or bad, and we are not sure that we could prove that one or the other offers a better solution to transparent reporting. Rules-based standards tend to open the door to loopholes that circumvent the spirit of the rules, while tying the hands of auditors who are forced to follow management's "legality." That is, it becomes more difficult to argue with a client who is "following" the letter of the rules. Conversely, principles-based standards may focus on reporting the true economic circumstances while offering so much latitude that auditors are challenged to discover management's misuse of flexible standards. Hence, trying to focus on one or the other will not result in a quick fix of the system. In the end, transparent financial reporting rests with integrity.

APPENDIX: ACCOUNTING STANDARD SCENARIOS AND QUESTIONS

PANEL A: RESEARCH AND DEVELOPMENT SCENARIO

Example--SFAS No. 2 Research and Development states "Research and development costs shall be charged to expense when incurred. Disclosure in the financial statements is required for the total research and development costs charged to expense in each period for which an income statement is presented."

In essence, as a rules-based standard, research and development (R&D) costs will be reported as an expense on the current period's income statement, even if the R&D results in something of value (e.g., a useful patent) that can be used to significantly increase revenues or reduce costs over a sustained period. In contrast, a principles-based standard would allow for judgment to be used in determining how to report R&D. If there is no value, the R &D cost would be expensed. However, when the R&D results in something valuable, it would be shown on the balance sheet as an asset, up to the amount of the related cost. This would facilitate multiple company comparisons.

PANEL B: REVENUE RECOGNITION SCENARIO

Example--ARB 43, Chapter 1A discusses Revenue Recognition noting that "Profit is realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured."

In essence, as a principles-based standard, revenue is recognized when the earnings process is essentially complete and the amount is collected or collectible. However, some rules-based standards have been developed to facilitate revenue recognition in special circumstances to meet the intention of the principles-based standard (e.g., when to recognize revenue when a company sends merchandise to distributors telling them they can return the goods if they cannot be sold in a reasonable time). Some of these rules-based standards were the result of companies having difficulty or failing to stay within the spirit of the principles-based standard. For example, SFAS No. 48, Recognition of Revenue When Right of Return Exists notes the following:

"If an enterprise sells its product but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized at time of sale only if all of the following conditions are met:

* The seller's price to the buyer is substantially fixed or determinable at the date of sale.

* The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product.

* The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product.

* The buyer acquiring the product for resale has economic substance apart from that provided by the seller.

* The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer.

* The amount of future returns can be reasonably estimated."

PANEL C: QUESTIONS ASKED AFTER EACH SCENARIO

Considering rules-based vs. principles-based standards, provide your preferences regarding the following items, by placing an X in the box beneath the answer that you believe is most appropriate:

* When considering rules-based vs. principles-based standards from the standpoint of a corporate manager in a company, I believe:

Rules- Rules- Neither Principles- Principles-
Based is Based is Rules- Based is Based is
Absolutely Somewhat Based or Somewhat Absolutely
Better Than Better Than Principles- Better Than Better Than
Principles- Principles- Based is Rules- Rules-
Based Based Preferable Based Based
 to the
 Other

* When considering rules-based vs. principles-based standards from the standpoint of an investor in a company, I believe:

Same scale as in Question 1

* When considering rules-based vs. principles-based standards from the standpoint of a creditor of a company, I believe:

Same scale as in Question 1

* Personally, when considering rules-based vs. principles-based standards, I believe:

Same scale as in Question 1

* Some have proposed that standards may need to be a mixture of rules-based and principles-based. Please note

below the degree to which you agree or disagree with this idea:

Strongly Disagree Neither Agree Strongly
Disagree Agree Or Agree
 Disagree

REFERENCES

Accounting Principles Board (1971). APB Opinion No. 20, Accounting changes.

Committee on Accounting Procedure (1953). ARB No. 43, Restatement and revision of accounting research bulletins.

FASB (1973). SFAS No. 2, Research and development.

FASB (1981). SFAS No. 48, Recognition of revenue when right of return exists.

FASB (2001). Reporting information about the financial performance of business enterprises: Focusing on the form and content of financial statements.

FASB (2005). SFAS No. 154, Accounting changes and error corrections.

FASB (2009). Financial statement presentation--Joint project of the IASB and FASB.

May, G.S. & D.K. Schneider (1988). Reporting accounting changes: Are stricter guidelines needed? Accounting Horizons, 2(3), 68-74.

SEC (1973). ASR No. 142, Cautionary advice regarding the use of "pro forma" financial information.

SEC (2001). Division of Corporation Finance: Frequently requested accounting and financial reporting interpretations and guidance.

Thomas J. Phillips, Jr., Louisiana Tech University

Andrea Drake, Louisiana Tech University

Michael S. Luehlfing, Louisiana Tech University

Table 1: Key Issues Concerning Financial Statement Transparency

1 What are the key financial measures (or indicators) that investors,
 creditors, and others use to assess and compare the performance of
 different enterprises in making rational investment decisions?

2 Are changes to existing standards needed to require the
 classification and display of specified line items, including their
 summarization and display of new financial measures in financial
 statements? For example, if EBITDA were identified as a key
 performance indicator, should companies be required to present
 EBITDA as a separate line item that is calculated in a consistent
 manner? If specified items of operating cash flow inflows or
 outflows were identified as key performance indicators, should
 companies be required to use the direct method of reporting
 operating cash flows?

3 Is it possible and desirable to distinguish between the effects of
 core (operating) and noncore (nonoperating) activities? If so, how
 should companies present core and noncore activities? For example,
 would such a classification scheme require new standards for the
 disaggregation of the components of net periodic pension expense or
 to allocate or classify items such as income tax expenses
 (benefits), holding gains and losses on financial instruments,
 restructuring charges, asset impairments, and extraordinary and
 unusual items.

4 Are there key measures of components of earnings that have
 complementary key measures of cash flows, and, if so, should
 consistent classification schemes be required for income statements
 and statements of cash flows?

5 If a financial instrument is recognized and measured at fair value,
 to what extent is the amount of interest or other items of income or
 expense contributing to the total change in fair value of the
 instrument a major factor in evaluating financial performance?
 Should companies separately display certain or all of the components
 of the change in value in an income statement?

6 Do alternative means of presenting a measure of comprehensive income
 affect a user's understanding of that measure and the weight given
 to that measure?

Source: Reporting Information about The Financial Performance of
Business Enterprises: Focusing on the Form and Content of Financial
Statements (FASB, 2001)

Table 2: Descriptive Statistics--Subject's Responses

 Revenue Sum of R&D
 R & D Recognition and Revenue
 Scenario Scenario Recognition.

Q1: Manager 3.17 2.89 6.06
 {4.00} {2.00} {6.00}
 (1.52) (1.30) (2.51)
 [4.00] [2.00] [4.00, 6.00 and 8.00]

Q2: Investor 2.89 2.67 5.56
 {2.50} {2.00} {5.00}
 (1.33) (1.31) (2.24)
 [2.00] [2.00] [4.00]

Q3: Creditor 2.47 2.61 5.08
 {2.00} {2.00} {5.00}
 (1.25) (1.42) (2.23)
 [2.00] [2.00] [4.00]

Q4: Personal 3.03 2.97 6.00
 {3.00} {3.00} {6.00}
 (1.30) (1.28) (2.28)
 [4.00] [4.00] [8.00]

Q5: Mixed 3.81 3.83 7.64
 {4.00} {4.00} {8.00}
 (.95) (1.03) (1.73)
 [4.00] [4.00] [8.00]

NOTE: All cells contain mean, {median}, (standard deviation) and
[mode]. N = 36 in all cells. The range for all individual responses
(except Q5: R & D scenario) was 1-5. The range for Q5: R & D was 2-5.
The range for all summed responses (except Q5) was 2-10. The range
for Q5 (summed) was 4-10. Q1-Q5 refer to questions 1-5 shown in
Panel C of the Appendix.

Table 3: Question Correlations Across Scenarios

 Q1: R&D Q2: R&D Q3: R&D Q4: R&D Q5: R&D

Q1: Revenue .571 **
Recognition (<.001)

Q2: Revenue .029 .439 **
Recognition (.868) (.007)

Q3: Revenue -.128 .083 .395 *
Recognition (.457) (.632) (.017)

Q4: Revenue .577 ** .099 .276 .570 **
Recognition (<.001) (.564) (.103) (<.001)

Q5: Revenue .329 * .258 .240 .175 .521 **
Recognition (.050) (.128) (.158) (.308) (.001)

Cells contain Pearson correlation, (p-value, two-tailed); N = 36

** Correlation is significant at the .01 level

* Correlation is significant at the .05 level

Q1-Q5 refer to questions 1-5 shown in Panel C of the Appendix.