Joint Effects of Principles-Based versus Rules-Based Standards and Auditor Type in Constraining Financial Managers' Aggressive Reporting

Managers sometimes implement accounting standards (such as the lease standard) opportunistically to move debt off balance sheet. Regulators and standard-setters are considering the adoption of principles-based accounting standards to reduce such opportunism. We report the results of an experiment in which experienced financial managers, with incentives to structure a transaction off balance sheet, take a reporting position on how a lease is to be reported. We manipulate the type of accounting standards (principles-based, rules-based) and the type of auditor (principles-oriented, rules-oriented, or client-oriented). Results show that for a rules-based standard, auditor-type does not influence participants' propensity to report the transaction off balance sheet. However, for a principles-based standard, auditor-type matters in that this propensity is lowest when the auditor is principles-oriented as opposed to rules- or client-oriented. Our results suggest that a move toward more principles-based standards is likely to result in improved financial reporting quality only when there is a corresponding shift in auditors' mindsets toward being more principles-oriented.