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

Accounting Scandals: Does Rules vs. Prin

Recent developments haveincreased the likelihood that U.S.regulators may permit the use ofInternational Financial ReportingStandards (IFRS) as well as (or perhapsin place of) Generally AcceptedAccounting Principles (U.S. GAAP)in the near future. On April 24, theSecurities and Exchange Commission(SEC) announced that it will considerallowing domestic companies to choosewhich type of accounting standardsto follow in reporting their nancialperformance. 1 In addition, PresidentBush signed an agreement with theEuropean Union on April 30 that will

seek to ensure conditions for theU.S. Generally Accepted AccountingPrinciples and International FinancialReporting Standards to be recognizedin both jurisdictions without the needfor reconciliation by 2009 or possiblysooner. 2 According to a recentarticle in The Wall Street Journal, thisagreement could provide the motivationfor American companies to drop U.S.GAAP for IFRS since the IFRS arewidely viewed as being more exible orprinciples-based whereas U.S. GAAPare often viewed to be more rigid or

rules-based.3

This study compares rules-basedversus principles-based accountingstandards across eight countries thatreported accounting scandals to seeif any association exists between thetype of accounting standards and theincidence of corporate and accountingfraud.

RULES-BASED GAAP VERSUSPRINCIPLES-BASED GAAP

IFRS are widely regarded to bemore principles-based than U.S. GAAP.

These principles-based accountingstandards emphasize the spirit ofthe accounting rules rather thanstrict adherence to a set of writtenrequirements. Mano, Mouritsenand Pace describe an April 2003advertisement by the accounting rmPricewaterhouseCoopers in The WallStreet Journal where the rm claimedthat:

Rules-based systems encouragecreativity (and not the good kind) innancial reporting. They allow some to

stretch the limits of what is permissibleunder the law, even though it maynot be ethically or morally acceptable.A principles-based system requirescompanies to report and auditors toaudit the substance or business purposeof transactions; not merely whetherthey can qualify as acceptable underincredibly detailed or overly technicalrules A rules-based system allowsmanagers to ignore the substance and,instead ask, Where in the rules does itsay 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 forallowing and even encouragingopportunistic managers to structuretransactions to produce misleadingnancial statements that their IPAs[Independent Public Accountants]would have to or could attest did fairlypresent the nancial conditions of thecorporation in accordance with generallyaccepted accounting principles. Inparticular, with respect to Enron, theaudit rm Arthur Andersen was chargedwith designing nancial instrumentsthat met the technical requirements of

GAAP while violating the intent. Publicdisclosure of Enrons procedures hasgiven rise to a renewed debate overwhether accounting standards should be

based on rules or principles. 5 However, as Katherine Schipper,

a former member of the FinancialAccounting Standards Board (FASB)points out, it is not that U.S. GAAPare not based on any principles, butrather that U.S. GAAP contain certainelements like detailed implementationguidance that makes them appear rules-

based. In practice, one may argue that

the detailed implementation guidancefosters an alleged current check-the-box or compliance mentality tonancial reporting that reduces therole of professional judgment in theapplication of the reporting rules. 6 As aresult, opponents of U.S. GAAP suggestthat moving to a more principles-basedsystem is desirable, because such asystem would encourage greater exerciseof professional judgment by accountantsand auditors.

COUNTRIES REPORTINGACCOUNTING SCANDALS

Starting with the list of 30 countriesused by the Ding, Hope, Jeanjean andStolowy (2007) study, we then cross-checked this list of 30 countries tothe IAS Plus Web site, maintained byDeloitte, which provides comprehensiveinformation about international nancialreporting. 7 More specically, this Website summarizes the use of IFRS asthe primary GAAP for reporting bydomestic companies by country andregion (available at www.iasplus.com/ country/useias.htm ). Based on this table,20 countries are classied as followingIFRS, the United States as the onlycountry that follows U.S. GAAP andthe remaining nine countries (Canada,India, Indonesia, Japan, Republic ofKorea, Malaysia, Pakistan, Thailand andTaiwan) as following neither IFRS norU.S. GAAP.

Only eight countries reportaccounting scandals during the2001-2005 period. These include theUnited States, that follows rules-basedaccounting standards, and sevencountries which follow the moreprinciples-based IFRS: Australia,

France, Ireland, Italy, the Netherlands,Switzerland and the United Kingdom.Thus, 13 countries which follow IFRS butdid not report any accounting scandalduring this period are excluded: Austria,Belgium, Denmark, Germany, Greece,Hong Kong, Norway, Philippines,Portugal, Singapore, South Africa, Spainand Sweden. Figure 1 describes theclassications of the remaining eightcountries.

In order to ensure that onlyscandals that were caused by anaccounting irregularity (like overstating

revenue by recording ctitious sales)rather than scandals caused by otherreasons (for example, insider trading) areincluded, we identify the source of theaccounting irregularities for each of thecompanies by utilizing various databasesincluding Lexis-Nexis, ProQuest,Stanford Law Schools Securities ClassAction Clearinghouse (available atsecurities.stanford.edu) and the SECsAccounting and Auditing EnforcementReleases (AAERs). For each corporatescandal identied, information relating

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to the main business sector in which thecompany operated and the year in whichthe scandal became public knowledge isobtained.

INCIDENCE OF ACCOUNTINGSCANDALS DURING2001-2005

Table 1 (see page 12) lists each ofthe corporate accounting scandals andwhether they occurred under rules-basedU.S. GAAP or the more principles-basedIFRS.

During the ve-year period 2001 to2005, accounting scandals at 38 companies became public knowledge under the U.S.rules-based GAAP system as comparedto only 12 companies under the moreprinciples-based IFRS system. Thus,during the period 2001 to 2005, more thanthree times as many accounting scandalswere reported in the United States thanin principles-based jurisdictions. Thisresult holds, even if we consider the totalnumber of publicly-listed corporations inthese eight countries.

There are approximately 6,811companies publicly listed in the UnitedStates versus approximately 6,892companies listed in the seven principles- based countries. During the period 2001-2005, 38 out of approximately 6,811, or0.56 percent, of listed companies reportedinstances of nancial misreporting inthe United States, while only 12 out ofapproximately 6,892, or 0.17 percent,

of listed companies reported instancesof nancial misreporting in the sevenprinciples-based countries. All otherthings being equal, this suggests that ahigher incidence of corporate accountingfraud occured inside the United States ascompared to outside the United States.

The magnitude of the accountingscandal was sufcient to trigger lingsfor Chapter 11 bankruptcy at 12 of the 38companies (or 31.6 percent) following U.S.GAAP, namely, Adelphia, Ashford.com,Delphi, Enron, Homestore.com, Liberate

Technologies, Mirant, NextCard, PeregrineSystems, Refco, Teltran International andWorldCom. Global Crossing also went bankrupt, but it was the deterioration of its

underlying businessrather than nancialmisreporting thatwas the primarycause. 8 The nancialmisreporting wastypically caused byimproper revenue

recognition and/or improper expenserecognition.

The magnitude of the scandals atthree companies (or 25 percent) using

principles-based standards, namely,HIH Insurance, Parmalat and CirioFinanziaria, was sufcient to trigger bankruptcy proceedings. The nature ofthe misreporting was rather dispersed,including improper revenue recognition,improper expense recognition, improperaccounting in connection with businesscombinations and direct violations ofaccounting principles. Additionally,the role of American inuence wasevident in two of the 12 companies(Royal Ahold and Alstom). Not only didthese two companies have U.S. stock

exchange listings, but their accountingproblems originated with their Americansubsidiaries. 9 Thus, it appears that themagnitude of the misreporting triggereda relatively higher number of bankruptcylings under U.S. GAAP as compared toIFRS.

Prior research also suggests that laxenforcement of IFRS may result in limitedcompliance with IFRS, thereby limitingtheir effectiveness. 10 One wonders whetherthe lower number of reported accountingscandals under the seven principles- based (international) regimes is partially

due to looser enforcement of accountingstandards in countries outside the UnitedStates.

CONCLUSIONThe results of the study show a

higher incidence of corporate accountingfraud occurs in rules-based United Statesas compared to the more principles- based countries. However, variation inenforcement levels and other cross-countrydifferences like legal environment andcorporate governance structure may bear

on the quality of information produced bynancial reporting conventions in differentcountries. 11 It is possible that a lowernumber of accounting scandals have beenreported in IFRS countries due to thesecross-jurisdictional differences. Even so,the results of this study raise the questionof whether the use of more principles-

based accounting standards would lead toa lower incidence of nancial misreportingin the United States. n

Endnotes1. Securities and Exchange Commission. SECannounces next steps relating to InternationalFinancial Reporting Standards. April 24, 2007.www.sec.gov/news/press/2007/2007-72.htm.2. The White House. Framework for advancingtransatlantic economic integration. April30, 2007. www.whitehouse.gov/news/releases/2007/04/20070430-4.html.3. Reilly, D. Whats better in accounting, rules orfeel?The Wall Street Journal . April 30, 2007 pp. C1.4. Mano, R., Mouritsen, M., and Pace, R.Principles-Based Accounting: Its not new, its notthe rule, its the law. The CPA Journal , Vol. 76(2006) pp. 60-63.5. Benston, G., Bromwich, M., Litan, R., andWagenhofer, A. Worldwide Financial Reporting: Thedevelopment and future of accounting standards.Oxford University Press . (New York, NY, 2006).6. Schipper, K. Principles-Based Accountingstandards. Accounting Horizons , Volume 17(2003) pp. 61-72.7. Ding, Y., Hope, O., JeanJean, T., and Stolowy, H. Differences between domestic accountingstandards and IAS: Measurement, determinants andimplications. Journal of Accounting and PublicPolicy , Vol. 26 (2007) pp. 1-38.8. Grant, R., and Visconti, M. The strategicbackground to corporate accounting scandals.Long Range Planning Journal , Vol. 39 (2006) pp.361-383.9. Ibid10. Ball, R., Kothari, S., and Robin, A. The effectof international institutional factors on properties ofaccounting earnings. J ournal of Accounting andEconomics , Vol. 29 (2000) pp. 1-51.11. Ruland, W., Shon, J., and Zhou, P. Effectivecontrols 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 QuinnipiacUniversity. She can be reached at alexis.nisbett@quinnipiac.edu . Aamer Sheikh, Ph.D., CPA, CBMis an assistant professor of accounting at QuinnipiacUniversity. He can be reached at aamer.sheikh@quinnipiac.edu .

See table on page 1

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Rules-Based GAAPCompany 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 ofCorporate Financial Misreporting During the Period 2001 - 2005