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Conservatism in Accounting: An Analytic Explanation and an Exploration of the Effects of Familiarity and Rules- vs. Principles-Based Standards

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Conservatism in Accounting: An Analytic Explanation and an Exploration of the Effects of Familiarity and Rules- vs. Principles-Based Standards
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Accounting interpretations ( jstor )
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Conservatism ( jstor )
FASB standards ( jstor )
Financial accounting ( jstor )
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Net income ( jstor )

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CONSERVATISM IN ACCOUNTING:
AN ANALYTIC EXPLANATION AND AN EXPLORATION OF THE EFFECTS OF
FAMILIARITY AND RULES- VS. PRINCIPLES-BASED STANDARDS
















By

IDIL RAIFE BURAT IMPINK


A THESIS PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
MASTER OF ARTS

UNIVERSITY OF FLORIDA


2006

































Copyright 2006

by

Idil Raife Burat Impink















ACKNOWLEDGMENTS

I am grateful to Gary McGill and Dominique DeSantiago for their unwavering

support. They have been the most wonderful mentors, friends, and bosses I could ever

wish for.

I thank David Sappington and Steven Slutsky for their help in finalizing my degree.

Finally, I thank my husband, Joost Impink, and my daughter, Selin Yaylali, for

helping me understand what matters most in life.
















TABLE OF CONTENTS

page

A C K N O W L E D G M E N T S ................................................................................................. iii

LIST OF TABLES ...................... ............... .. ..... ....... .............. vi

L IST O F F IG U R E S .... ......................................................... .. .......... .............. vii

A B STR A C T ... .................... ............................................ ... ....... ....... viii

CHAPTER

1 IN TRODU CTION ................................................. ...... .................

2 CON SERV A TISM PU ZZLE ............................................... ............................ 3

M measures of Conservatism .......................................................................... 6
B balance Sheet C onservatism ........................................... ........... ...............7
Incom e Statem ent Conservatism ........................................ ....................... 8
A ccruals C onservatism .................................................................................. 10
The Puzzling Evidence on Conservatism ....................................... ............... 12
T h e M o d el ...................................... ................................................. 1 5
N o Growth Case .................................. .. ... ... ..... ............ 16
G row th C ase .......................................................................20

3 THE EFFECTS OF RULES- VS. PRINCIPLES-BASED STANDARDS AND
FAMILIARITY .............. ................................ .......23

Theoretical Basis for Experiment Design ............ .............................................25
B background and H ypotheses ........................................ ................. ............... 27
Rules- vs. Principles-Based Standards ..................................... ............... 27
F a m ilia rity ..................................................................................................... 3 1
M e th o d ..........................................................................................3 2
E x p erim ental D esign ........................................ ............................................32
S u b j e c ts .......................................................................................3 4
P ro c e d u re ....................................................................................................... 3 4
M a te ria ls ....................................................................................................3 6
T h e c a se .................................................................................. 3 6
"Fam iliarity" m manipulation .............................. ............... 37
"Standards" m manipulation ........................................ ... ......... 38









R e su lts .................................................................................................... ....... . 4 0
D escriptiv e Statistics ........................................ ...................... .....................4 0
T he Joint D decision .............................................. ....................... 40
Manipulated Variables....................................................... 41
M manipulation Check for Fam iliarity ............................................................... 42
Additional Variable: Compensation/Class ............................... ................48
H hypothesis Tests .................. ............................ .. ..... ................. 48
D iscu ssion and L im station s.............................................................. .....................52
R results D iscu ssion ............ ...................................................... ...... .... ... .52
L im itatio n s ...................................................................................................... 5 5

4 C O N C L U SIO N ......... ...................................................................... ......... .. ..... .. 57

APPENDIX

HISTORICAL PERSPECTIVE ON THE DEVELOPMENT OF ACCOUNTING
STAN D ARD S ................................... .. ........... .............. .. 59

L IST O F R E FE R E N C E S ............................................................................ .............. 68

B IO G R A PH IC A L SK E TCH ..................................................................... ..................74
















LIST OF TABLES


Table pge

3-1. 2x2 between subjects design and the number of pair-wise observations in each
cell ......................................................................... 33

3-2. Experimental design and predictions...................... .... .......................... 34

3-3. Comparison of individual beliefs before and after the discussion with pair-wise
conclusions. ..................................................................43

3-4. Comparison of auditor and client beliefs with pair-wise conclusions.....................44

3-5. Number (percentage) of observations in "standards" manipulation..........................44

3-6. Number (percentage) of observations in "familiarity" manipulation......................45

3-7. Number (percentage) of observations when the joint decision is INVENTORY. ....46

3-8. Number (percentage) of observations when the joint decisions is INCOME. ..........46

3-9. Manipulation check for the familiarity variable for individuals.............................. 47

3-10. Manipulation check for the familiarity variable for paired individuals................47

3-11. Logistic regression model for single and pair-wise observations explaining pair-
w ise conclusions................................................... ......................... ....... 49

3-12. Logistic regression for simple effects test for familiarity using data collected at
individual level .........................................................................53
















LIST OF FIGURES

Figure page

2-1. Graph of earnings regressed on positive and negative returns..................................9

2-2. Cum ulative accruals by type......... .................................................. ............... 11

3-1. "Standards" m manipulation graph....................................................... .............. 45

3-2. "Fam iliarity" m manipulation graph................................................................. ....... 45

3-3. G raph of Table 3-7. ........................................... ... .... ........ .... .. ... 46

3-4. G raph of Table 3-8. ........................................... ... .... ........ .... .. ... 47















Abstract of Thesis Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Master of Arts

CONSERVATISM IN ACCOUNTING:
AN ANALYTIC EXPLANATION AND AN EXPLORATION OF THE EFFECTS OF
FAMILIARITY AND RULES- VS. PRINCIPLES-BASED STANDARDS

By

Idil Raife Burat Impink

May 2006

Chair: David Sappington
Major Department: Economics

The principle of conservatism is a major feature embedded in the financial

reporting system. Recently, there have been numerous empirical attempts to measure the

extent of conservatism that exists across firms and countries. The results of the empirical

studies based on different measures of conservatism are conflicting. This study explores

the principle of conservatism from analytic and behavioral perspectives.

The analytic section of this study attempts to unravel the conflicting results of the

archival studies and questions the extent to which accounting conservatism can be

measured empirically. The results of the analytic study show that a single measure of

conservatism does not exist and empirical studies that employ a single measure of

conservatism can not be relied upon to draw conclusions about the degree of

conservatism inherent in financial reporting.

In addition to quantitative factors, qualitative factors also need to be considered in

determining the degree of conservatism when decisions are made under uncertainty or









when decisions are made between parties that have a conflict of interest. The behavioral

section of this study explores two factors that may influence the degree of conservatism

that is observed in financial reporting. Specifically, this part explores the effects of rules-

vs. principles-based accounting standards and the influence of familiarity on conflict

resolution when auditors and their clients collectively decide on how an ambiguous

accounting issue should be reported in the financial statements. The results of the

experiment indicate that the type of standards and the degree of familiarity jointly have

an effect on the degree of conservatism inherent in the reported numbers. This is

important in showing how quantitative measures are affected by qualitative factors that

surround the decision making process.














CHAPTER 1
INTRODUCTION

Accounting conservatism is a major feature of the financial reporting system. The

saying "anticipate no profits and provide for all possible losses" (Devine, 1963; Watts,

2003a) describes conservative reporting on the income statement, which has inspired

most of the recent empirical research on conservatism (Ball, Kothari, and Robin, 2000;

Basu, 1997; Givoly and Hayn, 2000; Holthausen and Watts, 2001).

The most commonly used measures of conservatism in the literature are income

statement based as derived by Basu (1997), and balance sheet based assessments as

captured by the market-to-book ratio. The results of the empirical studies based on these

measures are conflicting.

In chapter 2, I attempt to unravel the conflicting results in the empirical literature

and I question the extent to which accounting conservatism can be accurately measured.

The results in chapter 2 indicate that conservatism can not be measured by a single

measure and that other factors may influence the conservatism in reported numbers.

I further explore the idea that qualitative factors may have an influence on the

degree of conservatism in financial reporting. In chapter 3, I explore this idea through an

experiment that examines two factors that may affect the joint decision of two parties that

have a conflict of interest. The auditor and the client are a classic example of two parties

known for their inherent conflict of interest. The client pays the auditor for auditing its

financial statements. Thus, the auditor can do a satisfactory job in the eyes of the client if

the auditor issues an opinion in line with the client's. The outcome of the joint decision






2


process reflects the degree of conservatism inherent in financial reporting. The results in

chapter 3 indicate that familiarity and the type of standards may jointly affect the

outcome of a joint decision making process.

Chapter 4 concludes the findings of the study.














CHAPTER 2
CONSERVATISM PUZZLE

The Financial Accounting Standards Board (FASB) Statement of Financial

Accounting Concepts (SFAC) No. 2 (1980) describes conservatism as the understatement

of net income and net assets in the presence of uncertainty. This description

encompasses conservatism as it is reflected on both the balance sheet and the income

statement. However, this does not imply that the effects of understatement will impact

both statements equally. Basu (2001) gives the following example:

It is useful to distinguish between the balance sheet and income statement effects of
conservatism, since they do not always go hand in hand. The purchase and
pooling-of-interest methods of accounting for mergers under U.S. GAAP provide a
useful illustration. Under the pooling-of-interest method, the acquired firm's assets
and liabilities are reported on the acquirer's balance sheet at the values on the
acquired firm's balance sheet, and depreciation typically continues under the pre-
existing basis. Under purchase accounting, the assets and liabilities of the acquired
firm are reported on the acquirer's balance sheet at fair values, which are typically
greater than their values reported on the acquired firm's balance sheet. However,
these assets are subsequently depreciated and/or amortized at rates higher than
those previously used by the acquired firm. Thus, the pooling method results in
more conservative balance sheets and less conservative income statements than the
purchase method, at least under the traditional definition. (p. 1335)

The reason why the effects of conservatism manifest in varying degrees in the

financial statements may be due to the fact that the conservatism principle overlaps the

two primary qualities of the financial statements: relevance and reliability. Relevance is

achieved through information that has predictive value, feedback value and that is timely.

Reliability is achieved through representational faithfulness, verifiability and neutrality

(SFAC No. 2). There exists a tradeoff between relevance and reliability: more relevance

can be achieved at the expense of reliability. Barth, Beaver, and Landsman (2001) state









that "conservatism can be a by-product of applying the FASB's reliability criterion" (p.

94). However, while on the one hand the conservatism principle requires more

verifiability for reporting good news, on the other hand the use of conservatism in

making judgments under conditions of uncertainty deters the neutrality of financial

statements. In addition to the statement in Barth et al., conservatism can also be a by-

product of the relevance criterion as it requires predictive value, feedback value, and the

timely recognition of "bad news" in the financial statements-but not "good news."

Thus, the concept of conservatism nurtures both of the primary qualities of the financial

statements in an asymmetric manner. Kieso, Weygandt, and Warfield (2001) label

conservatism as one of the "overriding constraints" to the qualitative characteristics,

which introduces yet another angle to the conceptualization.

Moreover, income statement and balance sheet conservatism may be applied at

varying degrees because of the different functions they serve. There may be different

forces at work pushing in opposite directions: more aggressive on the income statement

(as aggressive as possible that is allowed by the accounting standards) and more

conservative on the balance sheet (as conservative as possible that is allowed by the

accounting standards). For example, assuming that earnings provides a performance

measure for compensation contracting and monitoring purposes while the balance sheet

provides an estimate of the liquidation value of net assets for borrowing purposes, it is

understandable that income statements will be used by managers in a least conservative

manner whereas balance sheets will tend to err towards the more conservative end.

The empirical evidence collected based on operationalized definitions of

conservatism measures indicates that accounting practice has become more conservative

in the last 30 years (Basu, 1997; Givoly and Hayn, 2000; Watts, 2003b). Has accounting









really become more conservative in the past three decades? One of the most commonly

cited reasons for this increased degree of conservatism is the litigious environment that

was created after the 1966 changes in the rules of bringing class action suits (Watts,

2003a). The fear of litigation has supposedly forced accounting reporting to become

more conservative. Yet, could it be that litigation has increased because of aggressive

financial reporting and this has not necessarily made companies more conservative, but in

fact more calculative? Could there have been other changes at work that forced

litigations to increase?

An answer may be derived from Zeff s (2003a) review of the accounting profession

during the 20th century. According to Zeff (2003a), one major change that has affected

the large accounting firms in the last 30 years was the growth of consulting services,

which eventually led to the accounting profession succumbing to the mentality of

"making profits." In addition to this organizational change taking place within

accounting firms, financial reporting norms were also under stress during the 1980s as (1)

industry regulators increasingly viewed them as a means to achieving "public interest"

goals (e.g., regulators in the banking and thrift industries pressuring the FASB and the

audit firms to use deceptive accounting practices in order to "rescue" failing banks and

savings and loan institutions in the name of the "public interest") and (2) firms and trade

associations demanded more preparer-friendly standards from the FASB (Zeff, 2003a).

Furthermore, the 1980s was also the decade when analysts' earnings forecasts became

more prominent, which created increased pressure on CEOs to achieve earnings targets.

These developments led towards a more assertive and aggressive accounting

practice as auditors felt pressure from both inside and outside the accounting firm: on the

one hand companies wanting to secure auditor approval for creative accounting









techniques, and on the other hand the accounting firms wanting to keep the client's

business. The accountant's role diminished to one of "putting the foot in the client's

door" and once through the door, keeping the client happy. Not surprisingly, by the mid-

1980s all of the booklets and newsletters previously published by the large accounting

firms expressing views on controversial issues became nonexistent, which marks the

death of the accounting profession as it was known before (Zeff, 2003b).

The empirical research based on the operationalized definition of conservatism

hypothesizes that the most important explanations to conservatism are contracting and

shareholder litigation (Watts, 2003a). However, Begley and Freedman's (2004) study

provide evidence on the contrary. They investigate the changing role of accounting

numbers in public lending agreements and show that there is a dramatic decline in the use

of accounting numbers over the last quarter century. In the late 1970s, accounting-based

restrictions on dividends and additional borrowing appear in almost half of the debt

issues examined, in the 1990s the use of accounting-based restrictions falls down to 25

percent and in the 1999-2000 sample down to less than 10 percent. In the light of

empirical research on conservatism, which provides evidence that accounting practice has

become more conservative in the last 30 years because of contracting purposes, the

results of Begley and Freedman are puzzling.

Measures of Conservatism

Researchers have used various measures to gauge conservatism in financial

statements. These measures have been derived from three major accounting numbers:

net assets, earnings, and accruals (Watts, 2003b). Following is a description of each of

these measures labeled as balance sheet conservatism (utilizing net assets), income









statement conservatism (utilizing earnings), and accruals conservatism (utilizing

accruals).

Balance Sheet Conservatism

Balance sheet conservatism describes the choice of accounting methods and

estimates that keep the book values of net assets relatively low (Penman and Zhang,

2002). For example, LIFO accounting for inventories is conservative relative to FIFO;

accelerated depreciation for property, plant, and equipment is conservative relative to

straight-line depreciation; and expensing research and development (R&D) expenditures

is conservative compared to capitalizing these expenditures. One empirical measure of

conservatism emanates from the work of Feltham and Ohlson (1995), who model the

relation between a firm's market value and accounting data. They distinguish between

unbiased accounting and conservative accounting in terms of how book value differs

from market value. Based on Feltham and Ohlson's work, Zhang (2000) gives the

following definition of conservatism: An accounting policy is conservative if

limE,[oat,,]/E,[V,,,] <1 (Eq. 1)


where oa is operating assets and Vis the market value of operating assets. The market-

to-book ratio has been used as a proxy for balance sheet conservatism based on this

relationship (e.g., Givoly and Hayn, 2000; Lara and Mora, 2004). This implies that the

market-to-book ratio will be greater than one if companies are conservative on their

balance sheets.

The source of understatement of the book value relative to the economic value can

be due to: (1) the failure to capture the positive net present value of projects and

subsequent increases in value; (2) the minimization of the carrying value of net assets in

place; and (3) the prompt recognition of losses (Givoly, Hayn, and Natarajan, 2003). The









source of understatement that is due to the failure to capture the positive net present value

of projects and subsequent increases in value introduces the growth factor into the

market-to-book ratio. In fact, market-to-book ratios have been widely used to proxy for

growth in the financial literature where high (low) market-to-book ratio firms have been

described as growth (value) firms (Brealey, Myers, and Marcus, 2001; Fama and French,

1995, 1998). Thus, high market-to-book ratios can be an indicator of conservative

accounting practices on the balance sheet and/or high growth firms. The interaction of

accounting bias with growth is a well-known fact (Beaver and Ryan, 2000). Thus, at this

point, it becomes difficult to tease apart the conservatism embedded in the balance sheet

and the growth potential that is perceived by the market. Indeed, Penman and Zhang

(2002) state that this interaction of growth and conservatism-"the joint effect of real

activity and accounting policy" (p. 238)-can be used to manage earnings.

Income Statement Conservatism

Recently, Basu (1997) introduced a measure of conservatism that uses earnings and

stock returns to capture the conservatism principle implied by the adage "anticipate no

profits and provide for all the losses." He interprets conservatism as "capturing

accountants' tendency to require a higher degree of verification for recognizing good

news than bad news in financial statements" (p. 4). The measure of conservatism is

derived as the coefficient ,1 in the following regression:

X, / P, 1 = a, + aDR, + /,R, + 8,R, DR, (Eq. 2)

where the i and t subscripts denote the firm and period, respectively. Xis the earnings

per share, P is the price per share, R is the return from 9 months before fiscal year-end t










to three months after fiscal year-end t, and DR is a dummy variable that is equal to 1 if

R < 0 and 0 otherwise.

Basu describes conservative accounting as the asymmetric recognition of "good

news" and "bad news." The proxy for news is the sign of the stock return: good news

firms are those with positive stock returns and bad news firms are those with negative

stock returns. The coefficient /1 in Eq. 2, captures the incremental response of earnings

to bad news over the response to good news. Because companies provide for all the

losses and defer all gains, more timely recognition of bad news compared to good news

as measured by the /, coefficient implies more conservative accounting (see Fig. 1).

This operationalized measure of conservatism has been used in numerous studies to

assess the degree of accounting conservatism present across companies and countries

(e.g., Ball et al., 2000; Giner and Rees, 2001; Givoly and Hayn, 2000; Givoly et al.,

2003; Holthausen and Watts, 2001; Pope and Walker, 1999).

X

f,0 + /: slope for R<0 /0 : slope for R>0





/Figure 2-1. Graph of eaings regressed on positive and negative retu
------------------- R


/





Figure 2-1. Graph of earnings regressed on positive and negative returns.









Accruals Conservatism

Givoly and Hayn (2000) consider the above-mentioned definitions of conservatism

ambiguous. Their reason for ambiguity is the idea presented by Beaver (1998) in his

definition of conservative behavior: "what constitutes 'conservative' earnings behavior

in one period may imply 'non-conservative' earnings behavior in some later period" (p.

112). For example, both the balance sheet and the income statement will be affected in a

conservative manner when R&D expenditure is fully expensed in the period that they are

incurred, i.e., the company will have undervalued net assets and lowered net income in

the period of the expenditure but higher net income in the subsequent periods. Hence,

Givoly and Hayn (2000) state an alternative definition of conservatism that captures the

multi-period dimension as the "selection criterion between accounting principles that

leads to the minimization of cumulative reported earnings by slower revenue recognition,

faster expense recognition, lower asset valuation, and higher liability valuation" (p. 292).

They suggest that the sign and the magnitude of accumulated accruals over time are

measures that can be used to gauge the degree of accounting conservatism. "A consistent

predominance of negative accruals across firms over a long period is, ceteris paribus, an

indication of conservatism, while the rate of accumulation of net negative accruals is an

indication of the shift in the degree of conservatism over time" (p.292).

Givoly and Hayn (2000) calculate the accumulated total accruals as the difference

between cumulative net income (before depreciation and amortization) and the

cumulative cash flows from operations at the end of each of the years 1966-1998 and find

that for the period 1966 to the early 1980s, the firms generated net positive accruals and

from 1982 to 1998 there was a continuous accumulation of negative accruals, which they

interpret as evidence that financial reporting has become more conservative. They break










down the cumulative total accruals into cumulative operating and cumulative

nonoperating accruals and find that it is the cumulative nonoperating accruals that have

become increasingly negative, whereas cumulative operating accruals have become

increasingly positive (see Fig. 2). They assert that this predominance of negative

cumulative nonoperating accruals cannot be explained by restructuring charges, mergers

and acquisitions, increased cost of pension and post-retirement benefits, growth, and

inflation based on additional analysis that controls separately for each of these factors

(their results for this additional analysis are not reported in their paper).




1500000 -


1900000









-- [4]

-1500000 -

--- Cumuatite Tld1.i A-Xuals lbe!,re daFprciallri1l
-2W000 ...... Curnulaldiv Operating Acruals [2]
rr^Cui~walovte Nfrupyeatinii AcclIuse[3]
S...-...... Curmiatlve Non~pnliring A uual wfo Speial ILnis & Disc. Oprr. [4]


Figure 2-2. Cumulative accruals by type, 1965-1998 (constant sample of 896 firms).
Total Accruals (before depreciation): (Net Income + Depreciation) Cash
Flow from Operations. Operating Accruals: AAccoutns Receivable +
AInventories APrepaid Expenses AAccounts Payable ATaxes Payable.
Nonoperating Accruals: Total Accruals (before depreciation) minus
Operating Accruals. Source: Givoly and Hayn (2000), Fig. 1, p. 303.









The Puzzling Evidence on Conservatism

Numerous studies have been conducted based on the above-mentioned measures of

conservatism (e.g., Ball et al., 2000; Basu, 1997; Givoly and Hayn, 2000; Holthausen and

Watts, 2001). Some of the conclusions that emerge from these empirical studies are: (1)

the U.S. financial reporting is conservative (Basu, 1997); (2) the U.S. financial reporting

has become increasingly conservative (Givoly and Hayn, 2000; Holthausen and Watts,

2001); (3) the financial reporting system in common law countries (the U.K., Australia,

Canada, the U.S.) is more conservative compared to the financial reporting system in

code law countries (France, Germany, Japan) (Ball et al., 2000).

While Basu (1997) and Givoly and Hayn (2000) show that the U.S. is conservative

and that financial reporting has become increasingly conservative using the income

statement conservatism measure, Bowen, DuCharme, and Shores (1995) directly examine

firms' choices of depreciation and inventory methods during the 1980s and early 1990s,

and find a near-monotonic and large shift towards straight-line depreciation and FIFO

from accelerated depreciation and LIFO, which indicates conservatism has been

decreasing over time in the U.S.

Ball et al. (2000) explain their findings based on the differences that the law system

creates. They theorize that in common law countries, where companies are mostly

owned by the public, there is a demand for public disclosure that induces conservative

reporting by the companies in order to protect themselves against litigation. On the other

hand, this lack of demand for public disclosure in code law countries does not require

conservative reporting, because companies are mostly owned by financial institutions or

families and thus information asymmetries are resolved privately.









An inherent tension in the argument of Ball et al. is that while on the one hand

there is a demand for public disclosure that induces conservative behavior, on the other

hand the same public demands accurate, unbiased financial reporting. Gigler and

Hemmer (2001) show that companies with more conservative accounting are less likely

to make timely voluntary disclosures compared to those with less conservative

accounting and thus, they conclude that price more timely reflects the news of firms with

less conservative accounting. Moreover, even though the U.S. is more conservative as

measured by Ball et al. (2000), Pope and Walker (1999) show that the differences

between the U.K. and the U.S. reverse when the analysis is done based on earnings after

extraordinary items, i.e., the U.K. becomes more timely in the recognition of bad news

compared to the U.S. This raises two questions: (1) whether financial reporting is

comparable across countries even though they use similar law systems and (2) whether

the income statement conservatism measure is sensitive to the definition of earnings.

Pownall and Schipper (1999) provide an answer to the first question by addressing the

differences that exist between U.S. GAAP and non-U.S. GAAP. They state that

"speaking to the type and magnitude of noncomparabilities as captured by Form 20-F

reconciliations, research generally finds substantial negative differences between U.S.

GAAP and home GAAP income, consistent with U.S. GAAP being on average more

conservative than non-U.S. GAAP and consistent with a lack of aggregate comparability"

(p. 264).

Another empirical example is provided by Giner and Rees (2001). They state that

"an examination of the accounting practices suggests that pervasive conservatism would

be greatest in Germany-the classic 'stakeholder-code law' area, intermediate in France

and least apparent in the U.K. It may be expected that the more developed equity market









in the U.K., and the more frequent occurrence of widely held firms, would discourage

pervasive conservatism, as it might be expected to produce earnings numbers of less

relevance to shareholders, and to reflect badly on the reputation and remuneration of

managers" (p. 1299). However, the empirical evidence using the income statement

conservatism measure points in the exact opposite direction: the U.K. is the most timely

in recognizing bad news (i.e., most conservative) compared to the 'code-law' countries,

France and Germany. Germany turns out to be the least conservative of the three. Giner

and Rees (2001) also show that in the U.K., firms with low (high) market-to-book ratios

have higher (lower) income statement conservatism. This would indicate that the two

conservatism measures point in opposite directions.

Lara and Mora (2004) reach similar conclusions and find that the existence of

balance sheet conservative practices is associated with reduced levels of earnings

conservatism. Givoly et al. (2003) explain why balance sheet conservatism may produce

lower income statement conservatism as follows:

The application of conservative accounting methods and practices such as
expensing of software development costs, providing for anticipated losses, the
immediate write-off of goodwill upon acquisition and the use of accounting
methods such as LIFO and accelerated depreciation, would minimize the book
value of net assets. As a result, the application of lower-of-cost-or-market-rule will
be less frequent and the greater responsiveness of earnings to subsequent bad news
will tend to be less pronounced. In contrast, aggressive reporting in the form of
extensive capitalization and inadequate provisions for future costs or losses will
make the firm's earnings more sensitive to unfavorable economic events. (p. 6).

They provide evidence that the income statement conservatism measure (which

they label as the differential timeliness (DT) measure), is not related to the rate of

accumulation of negative accruals (also for nonoperating accruals) and is negatively

correlated with other dimensions of conservatism.









Pae, Thornton, and Welker (2004) show that income statement conservatism is

substantially greater in portfolios of firms with lower price-to-book ratios than in

portfolios of firms with higher price-to-book ratios and further find that the negative

association between income statement conservatism and the price-to-book ratio is

primarily due to the accrual component of earnings. In the following section a model is

presented to explain these empirical results.

The Model

The company is assumed to be an all-equity firm.1 The market value of the

company is denoted by V and defined as the present value of all the future dividends.

The stock return, R, is:

S-Vl +DIV(Eq.3)
R, = (Eq. 3)
Vt-1

The market-to-book ratio will be used to capture the degree of conservatism on the

balance sheet and the growth factor. In order to model the effects separately, the market-

to-book ratio will be split into two ratios:

V V M
=- x (Eq. 4)
B M B

where M denotes the market value of net assets in place and B denotes the carrying value

of net assets on the balance sheet. Vis the market value of the firm: sum of the market

value of current assets in place and the market value of net present value of future

projects. Modeling the market-to-book ratio this way enables the capture of the different

sources of understatement mentioned in Givoly et al. (2003). V /M can be interpreted as

capturing the growth factor as valued by the market since the features of financial

1 An all-equity firm is assumed for mathematical ease. The analysis can be extended to debt-financed firms
without loss of generalizability.









reporting (e.g., historical cost convention) do not allow for the valuation of net present

value of future proj ects. M/ B can be interpreted as capturing the degree of conservatism

on the balance sheet that is purely due to accounting choices. For example, if V = M,

this means that the net present value of future projects is 0 and that this is a no-growth

firm. When this is the case, V /B =M /B, i.e., market-to-book ratio measures the degree

of conservatism on the balance sheet without the interaction of the growth factor.

Therefore, accounting choice and regulation are the only forces behind conservative

practices via minimization of the carrying value of net assets in place. However,

when V # M, then the market-to-book ratio becomes a noisy proxy for conservatism on

the balance sheet because of the interaction between growth and conservatism.

No Growth Case VIB=VIMxMIB=MIB

Assume that the company has no positive present value projects so that V /M = 1.

In this case, V / B is purely an indicator of conservatism on the balance sheet. The

degree of balance sheet conservatism will be denoted by a. a is the book-to-market

ratio, the inverse of the market-to-book ratio:

Bt, = O-i (Eq. 5)

Thus, 0 < a <1 captures the degree of balance sheet conservatism that exists at the

beginning of the period, i.e., increased a implies less conservatism on the balance sheet.

For example, in the extreme case where a = 0, the company has expensed all of its

assets; o = 1 implies fair-value accounting, i.e., book value equals market value; and

a > 1 implies overvaluation of assets with respect to the market value.

The accounting earnings per share, X, will be assumed to be calculated using the

historical cost, revenue recognition and matching principles. Assume that there no









dividends paid out2 and that the market incorporates all kinds of information into the

market price (i.e., efficient markets hypothesis), then the reported earnings per share, E,

will be the minimum of accounting earnings or the difference between the market value

and the beginning book value (because of the application of lower-of-cost-or-market rule

(LCM)):

E, = min[X, V B,] (Eq. 6)

The LCM dictates departure from the historical cost principle when the market

value of the assets in place is no longer as great as their original cost. Thus, the company

can report its accounting earnings when the difference between the market value and the

beginning book value is at least equal to the current accounting earnings amount, but

reported earnings have to be adjusted when this difference is less than the current

accounting earnings, which implies that there has been a downward market valuation of

the company's assets in place.

Substituting Eq. 5 into Eq. 6 results in:

E, = min[X, V, -og1] (Eq. 7)

Adding and subtracting Vt, to the second term in Eq. 7 yields the following:

E, = min[X,, V, + (1 -) V 1] (Eq. 8)

Thus, reported earnings can either report the accounting earnings for the current

period or a garbled number based on the market's valuation. (1 o)V,, can be

interpreted as the "reserve" that has been created via conservative behavior on the

balance sheet. For example, if the company's degree of conservatism, a, is 0.90, then


2 This is assumed for ease of discussion. It does not change the interpretation of the following analysis.









the book value is 90 when the market values it at 100. Thus, the company has created a

"reserve" of 10.

Assuming that 0 < a < 1, i.e., the company's balance sheet is not overvalued

compared to the market, the reported earnings amount depends on two things: the

comparison between the cost of equity capital, r, and the stock returns, RP; and a, the

degree of balance sheet conservatism:

1. If r < RE, then E = X always. This means that if the market perceives a positive
change in value over the period (i.e., "good market news"), the reported earnings
will always equal realized earnings. In this case, the degree of balance sheet
conservatism, a, does not matter.

2. If r > R,, i.e., "bad market news," then the reported earnings depends on the
magnitude of the decrease in market value of assets and the degree of balance sheet
conservatism:

a. If X, < VT -_ V + (1- o)V _, then E = X as in case (a). The accounting
earnings are less than the change in market value and the "reserve" created
via balance sheet conservatism. Notice that increased "reserves" on the
balance sheet will help this relationship to hold. Thus, the magnitude of
the "bad market news" can be hidden behind the balance sheet
conservatism and the company does not have to incorporate the "bad
market news" into its accounting earnings.

b. If X, > V V, + (1 c)V, then E= V V + (1 c)V,_. The
accounting earnings are greater than the change in market value and the
"reserve." The company has to incorporate the decrease in value of its
assets as perceived by the market and into its current reported earnings.
Notice that higher "reserves" created via balance sheet conservatism will
enable the company to report higher accounting earnings than the
economic income.

The income statement conservatism as captured by the regression in Eq. 2 implies

that returns and earnings are more highly correlated when the stock returns are negative.

If stock returns are negative, then:

R V V, + DIV >
V= t V-1









Given that conservatism is applied as described above to the reported earnings, then

the correlation between stock returns and reported earnings is as follows:

p = correlation(R, E)
V V (Eq. 9)
= correlation( V '- min[X,, V, V,1 + (1- a) ])q.
t-i


If r < R, then pG = t X,)
t-1


If r >R, then p, = p( J-- X,) or p( V-,-V +(1- a) ,)
t-1 t-1

Thus, p, > PG, the correlation between returns and reported earnings will be much

higher in case 2-especially when the company cannot rely on excess "reserves" created

by conservative practices on the balance sheet and when the V V, < 0 constraint is

imposed (assuming that cost of equity capital is a positive number). Hence, the

companies that are deemed to be more timely in capturing bad news cannot necessarily

be described as reporting in a conservative manner. The above analysis shows that these

companies are in fact less conservative on their balance sheet and their timeliness in

capturing bad news is because they cannot "hide" their "bad market news" and they are

forced to reveal it in line with the market. Moreover, the higher the balance sheet

conservatism, the easier it is to report the accounting earnings without worrying about the

LCM rule, because assets in place have already been written down much lower than the

market's valuation. Hence, the correlation between returns and reported earnings would

be lower, which explains, for example, why Germany, a country considered to be very

conservative on its companies' balance sheets shows up as the least timely country in

reporting bad news. This analysis explains the recently documented empirical results on

the relationship between income statement and balance sheet conservatism. However, it









should be noted that the relationship is not a linear one, but rather one that depends on the

degree of balance sheet conservatism and the magnitude of the change in value as

perceived by the market.

Growth Case V/B=V/IMxM/B=VI/M

Now assume that the company reports its carrying net assets in an unbiased manner

on the balance sheet so that M IB = 1, i.e., the balance sheet is reported at fair value3. In

this case, V/B is purely an indicator of the expected growth of the assets in place.

Assume that earnings still follow the conservatism principle as implied in the

saying, "anticipate no profits and provide for all the losses." Now assume that there is a

surprise element in the reported earnings that the market reacts to:

x = E[x]+ x (Eq. 10)

where x is the rate of return on equity (ROE), i.e., E / B 1; E[x] is the expected

ROE, i.e., E[E,]/B,- ; and x, denotes the unexpected portion of the ROE, i.e., UE/B,

(where UE denotes the unexpected portion of reported earnings). Given the surprise

element in the earnings, the stock returns, R, will be:

R= E[R]+R (Eq. 11)

where E[R] is the expected rate of return and RJ denotes the unexpected stock

returns, i.e., UR / V (where UR denotes the unexpected change in valuation).

If the surprise in earnings were reported in an unbiased manner, then the

numerators of the unexpected ROE and the unexpected stock returns would be equal to

each other, i.e., UE = UR. However, since the earnings are known to follow the


3 This assumption is not necessary for the analysis. It is assumed in order to isolate the effect of growth
from biased reporting on the balance sheet.









conservatism principle, the market valuation of the unexpected portion of the earnings

will be in the following way:

1. UE < 0 : There is unexpected "bad company news" reported in earnings. Because
the market knows that the company has to exercise the conservatism principle on
the income statement by accounting for the worst case scenario, the stock return
adjustment will exactly equal the unexpected "bad company news," i.e., UR = UE.

2. UE > 0: There is unexpected "good company news" reported in earnings. Again,
the market knows that the financial reporting system does not allow for the
complete recognition of "good company news" before the related earnings are
completely realized. Now, assume that the positive earnings surprise is permanent4
and is expected to grow at a rate ofg determined by the market (that is less than
E[R]). Then the unexpected change in valuation of stock will be calculated in the
following way:
UE
UR = UE + U (Eq. 12)
E[R]- g

Income statement conservatism is driven by asymmetric recognition of gains and

losses. As growth does not imply unexpected "good company news" or unexpected "bad

company news," a given level of growth in present value projects should not affect the

income statement conservatism. However, the stock market reaction to the unexpected

news as reported by the company depends on the growth factor.

The income statement conservatism as measured by Basu (1997) (see Eq. 2)

measures the differential effect of negative returns and positive returns on earnings. If

the company is a growing company, then the difference between positive returns and

negative returns will be greater with increased growth (growth is assumed to be less than

expected stock returns) since the denominator in Eq. 11 will get smaller with higher

growth resulting in greater positive stock returns when there are positive earnings



4 Even though this is not a realistic assumption, it does not change the interpretation derived from the
analysis. Assuming that there are transitory and permanent components to the positive earnings surprise
would decrease the numerator in Eq. 12, but the unexpected change in market price would still be higher
than the earnings surprise.









surprises. Hence, a market-to-book ratio greater than 1, which indicates positive growth

in this case, will result in higher income statement conservatism (where there is no

balance sheet conservatism).

By splitting the market-to-book ratio into two portions, one measuring the growth

factor, VIM, and the other measuring the conservatism factor, M/ B, the interaction of

growth with conservatism and how it affects income statement conservatism is observed.

Income statement conservatism is increasing in VIM and decreasing in M /B.

Therefore, given the growth and no-growth scenarios, two conflicting results

emerge with respect to the relation between income statement conservatism as measured

by Basu (1997) and balance sheet conservatism as measured by the market-to-book ratio:

(1) when there is no-growth, higher income statement conservatism is associated with

lower market-to-book ratio and (2) when there is growth and no balance sheet

conservatism, higher income statement conservatism is associated with higher market-to-

book ratio. Thus, the link between income statement conservatism and balance sheet

conservatism cannot be adequately interpreted without accounting for the growth factor.














CHAPTER 3
THE EFFECTS OF RULES- VS. PRINCIPLES-BASED STANDARDS AND
FAMILIARITY

Among the most cited causes of the current accounting crisis are overly complex

accounting standards, emphasis of form over substance in applying accounting standards,

and the failed independence of auditors (Piecara, 2002). The Sarbanes-Oxley Act of

2002 includes provisions aimed at the removal of these fundamental problems. There are

two important provisions in the Act that closely relate to the topic of this chapter.

Section 108 of the Act instructs the SEC to study the feasibility of adopting a principles-

based accounting system. Section 203 of the Act requires the rotation of audit partners

every five years and Section 206 prohibits the audit of a company if the company's CEO,

CFO, controller, CAO or person in equivalent position has been employed by the audit

firm during the one-year period preceding the audit.

An overlooked point by the experimental studies conducted in prior literature to

discern the varying effects of rules- vs. principles-based standards on decision-making is

that the auditing process is embedded in an interactive relationship between the auditor

and the client. Antle and Nalebuff (1991) pointed out that the financial statement

"becomes a joint venture if the auditor is unwilling to provide an unqualified opinion on

management's stated representations." In other words, whenever there is a disagreement

on the reporting decision of accounting issues, the auditor and the client will have to

collectively resolve the conflict in order to issue an unqualified opinion.









I designed an experiment where the impact of rules- vs. principles-based standards

can be explored within the context of the existing relationship between the auditor and

the client. Magee and Tseng (1990) showed that there exists a link between auditor

independence and the type of standard. Thus, a factor that naturally has to be considered

and included in such an experimental setting is the degree of familiarity between the

auditor and the client. This is especially so when auditor independence has been the

concern of many regulatory agencies and the accounting profession (Glazer and Jaenicke,

2002).

The experiment was conducted using senior and graduate students studying

accounting. In the experiment, the students were assigned to pairs, where one was asked

to role-play as the auditor and the other was asked to role-play as the client. The auditors

were instructed to question the reporting of a certain accounting transaction by their

clients, which increased the net income of the company and were asked to suggest an

alternative way of reporting to their clients. Both the auditors and the clients were

provided with current GAAP that supported their point of view. "Threat of lawsuits" and

"threat of client loss" could possibly influence the outcome of the mini discussion by

giving the client an upper-hand (Farmer, Rittenberg, Trompeter, 1987). To remove the

possible effects of these factors, the subjects were informed that there was no threat of

litigation and the client could not fire the auditor.

The collective reporting decision of the auditor and the client depended upon (1)

whether they employed rules-based or principles-based standards to discuss the

accounting issue, and (2) whether they personally knew each other or were meeting for

the first time. The pairs were asked to discuss the issue and make a joint decision. Pair-

wise conclusion was the binary dependent variable and could either be INCOME as









favored by the client or INVENTORY as favored by the auditor. The type of accounting

standard employed in determining the appropriate reporting method was manipulated

between subjects, as was the familiarity factor. The results indicated that the likelihood a

client agrees with an auditor's position increases when the auditor and the client resolve

the issue using rules- rather than principles-based standards. Familiarity by itself did not

have an impact on pair-wise conclusions. However, familiarity and the type of standards

jointly affected the outcome of conflict resolution between the auditor and the client.

When the client and the auditor were not familiar with each other, the pair-wise

conclusion was not dependent on the type of accounting standards employed. However,

when the client and the auditor were familiar with each other, the likelihood that the

conclusion was in client's favor increased when principles-based standards were

employed, and the likelihood that the conclusion reflected the auditor's opinion increased

when rules-based standards were employed.

Theoretical Basis for Experiment Design

Gibbins, Salterio, and Webb (2001) develop a model of auditor-client accounting

negotiation and design a field questionnaire that was completed by audit partners about

real negotiations with clients. Negotiation is defined as any context in which two or more

parties with differing views jointly make a decision that affect the welfare of both parties.

The negotiation process is described as a three-element process model, which begins with

an accounting issue (based on past negotiations or relationships between the parties),

followed by different choices and actions that constitute the auditor-client process, and

results in a negotiation outcome. In this process, each negotiation has the potential to

become an antecedent for the next negotiation, making it a continuous round of

discussions until a final resolution is reached. The three-process model is closely









associated with accounting contextual features that provide practical meaning to the

model. These features are external conditions and constraints, interpersonal context, and

parties' capabilities (Gibbins et al., 2001).

The experiment was designed to replicate one round of this three-element process

model. The subjects were provided with an accounting issue along with a brief history of

the auditor-client relationship; the auditor and the client were asked to discuss the issue

between them; and an outcome was required to be reported at the end of their discussion.

The conflict was created by instructing the auditor and the client to adopt opposing points

of view.

Gibbins, McCracken, and Salterio (2003) explore the client side of the same

negotiation process described in Gibbins et al. (2001). In both studies, the audit partners

and the CFOs report accounting and disclosure standards as one of the most important

external factors during auditor-client negotiations. In both studies, the relationship with

the "other side" constituted one of the most important interpersonal factors. This

outcome can be somewhat biased since the length of the relationship between the auditor

and the client in both studies was reported to be more than three years for most of the

sample, indicating that most were already familiar with the person they were negotiating

with. The experiment was designed to isolate the effects of these two important factors

from the other contextual factors and to reveal the impact they may have on the

accounting outcome when the negotiation was limited to only one round of discussion.

A puzzling issue that arises from the joint analysis of both papers is the reported

outcome of the negotiated issue. 32% (19%) of the audit partners (CFOs) reported that

the negotiation outcome was agreement on auditor's original position whereas only 4%

(34%) of the audit partners (CFOs) reported that the negotiation outcome was agreement









on client's original position. The percentages reported in both studies tell opposing

stories as to whose original positions wins at the end of a negotiated issue. Since both

these studies are field questionnaires collecting subjective information, it is not possible

to objectively verify the reported percentages. The designed experiment has the potential

to provide insight into this puzzle.

Background and Hypotheses

Rules- vs. Principles-Based Standards

A closer look at the development of standards and the definition of rules- vs.

principles-based standards is necessary in order to understand how we came upon the

debate and distinction between rules- vs. principles-based standards.

The need to develop a comprehensive set of accounting standards first arose after

the market crash in 1929. Since then, there have been other major market crashes, the

most recent being the so-called "burst of the Tech Bubble." The aftermath of almost

every market crash has eventually led to the questioning of accounting standards in effect

at the time, their structure, and whether they had been comprehensive enough to predict

or to prevent the imminent crash (refer to appendix for a summary of historical account

of the development of standards).

After nearly a century of developing accounting standards, the debate on rules- vs.

principles-based standards is fueled once again. It is important to understand what is

meant by these terms. A likewise distinction is made in the law literature between rules

vs. principles. Brasil, Jr. (2001, pp. 67-68) summarizes the law literature on rules and

principles as follows:

* Dworkin (1978) claims that rules have "absolute obligations equivalent to 'all-or-
nothing'" whereas principles do not have this kind of absolute obligation.









According to Dworkin, principles are selected based on the importance of the value
they attain to whereas rules are not value-laden.

* Alexy (1978) claims that one way of distinguishing rules from principles is "the
abstraction degree on their prescriptions," which is not just a matter of degree but
also a matter of quality.

* Peczenik (1989) assumes that "principles are normative propositions" and not
descriptive statements.

* Verheij (1996) proposes that the difference between rules and principles is merely
gradual and that there is "no difference in logic structure" between the two.

Recent accounting literature has made the distinction along parallel lines. Vincent

et al. (2003) "characterize the standard setting-process and its products along a

continuum ranging from unequivocally rigid standards on one end to general definitions

of economic-based concepts on the other end" (p. 74). The rigid end of the spectrum

leaves no room for judgment or disagreement whereas the general end of the spectrum

requires the application of professional judgment and expertise both by managers and

accountants.

Nelson (2003) defines rules- vs. principles-based standards in a similar way by

adopting the "incremental perspective." He views all standards as principles-based since

the FASB is assumed to be issuing standards based on the conceptual framework. Thus,

he characterizes the "issue as the incremental effect on behavior when standards include

relatively more elaborate rules." He focuses on the incremental effects of increasing the

number of rules in a standard where he defines rules to "include specific criteria, 'bright

line' thresholds, examples, scope restrictions, exceptions, subsequent precedents,

implementation guidance, etc." (p. 91).

The FASB has issued a "Proposal for a Principles-Based Approach to U.S.

Standard Setting" (FASB 2002) in response to concerns about the quality and









transparency of financial reporting. There are mixed reactions to the proposal. Some

academics find the proposal in conflict with the existing constraints posed by the legal,

technological, and business environment (Schipper, 2003), while others embrace the

notion on the grounds that managers use rules-based standards to structure transactions

(Nelson, 2003; Vincent et al., 2003).

Initially, the accounting profession has been concerned about the lack of

accountants' power over their clients (Sterling, 1973). The issuance and application

requirement of more strict and clear rules have been viewed as an "empowering" tool for

the auditor against clients who are inclined to interpret standards in a way that justifies

their aggressive reporting decisions. This perspective has resulted in a highly technical,

complex, and detailed set of accounting standards. Magee and Tseng (1990) found that

auditor independence is easier to maintain when standards leave little room for

disagreement among auditors. However, more recent research clearly pointed out that

replacement of vague standards with precise standards does not mitigate aggressive

reporting in tax contexts (Cuccia, Hackenbrack, and Nelson, 1995). Based on the results

of Cuccia et al., one can make the analogy that using rules- vs. principles-based standards

should not necessarily have an effect on the reporting decision of auditors. Hackenbrack

and Nelson (1996) further explore the issue in the audit arena while introducing an

additional factor that might mitigate the aggressiveness of auditors' reporting decisions,

namely the engagement risk. Results of their study indicate that the nature of standards

does not influence the outcome of the reporting decision: They showed that under

moderate engagement risk, auditors permitted aggressive reporting method by their

clients under both rules- vs. principles-based standards, whereas under high engagement

risk, the auditors reverted to more conservative interpretation of standards.









Recently the perspective that rules-based standards "empower" auditors has

suddenly swung in favor of the clients: rules-based standards now are perceived to

"empower" clients by enabling them to structure transactions to manage their earnings.

This is currently quoted as one of the main reasons why regulators want to revert to

principles-based standards. Nelson, Elliott, and Tarpley (2002) analyzed data collected

from 253 auditors on 515 specific earnings management incidences by using a field-

based questionnaire. Their results indicated that managers are more likely to attempt

earnings management by structuring transactions using "high precise" standards [i.e.,

rules-based] rather than "low precise" standards and that auditors are less inclined to

interfere with such attempts. On the other hand, the percentage of earning management

attempts adjusted by the auditor was still higher for the "high precision" standards (51%)

compared to the "low precision" standards (39%). In addition, the number of earning

management attempts was higher for the "low precision" standards (313) compared to the

"high precision" standards (202).

In this experiment, the type of standards is manipulated between subjects to

examine the impact of rules- vs. principles-based standards on the outcome of conflict

resolution. Since the recent literature indicated that different types of standards do not

mitigate aggressive reporting of auditors and since this fact would only be exacerbated by

closer relationships between the auditor and the client, the hypothesis stated in alternative

form is as follows:

H1: The likelihood that a client agrees with an auditor's position increases when

the auditor and the client resolve the issue using rules- rather than principles-based

standards.









Familiarity

The accounting literature on familiarity is fairly limited in scope and explores the

issue only from the accountants' side. Most studies conducted on the topic are limited to

the effects of familiarity in the audit setting concerning the relationships between the

senior auditors and their staff (Asare and McDaniel, 1996; Ramsay, 1994; Wilks, 2002).

There are no behavioral studies that explicitly examine how familiarity between the

auditor and the client may affect the outcome of an actual discussion between the two

with regard to the reporting decision of a conflicting accounting issue. An emerging

theme from the existing studies is that familiarity with the group members of an audit

team can potentially become a source of judgment bias in the team's performance (Tan

and Jamal, 2001; Asare and McDaniel, 1996). Likewise, long running interactions

between the client and the auditor can also be a potential source of judgment bias

(Dopuch, King, and Schwartz, 2001) and a threat to auditor independence (Glazer and

Jaenicke, 2002), which explains why the Sarbanes Oxley Act includes specific provisions

for auditor independence. The implicit assumption underlying the mandatory rotation of

auditors is that potential economic gains from continuing interactions with the same

client undermine auditor independence (Dopuch et al., 2001).

This experiment manipulates the degree of familiarity between-subjects to examine

its effect on the outcome of a conflict resolution. The second hypothesis is:

H2: The more familiar an auditor is with a client, the more likely s/he is to agree

with a client's position.









Method

Experimental Design

An experiment was conducted to test the effects of different types of standards and

familiarity on the resolution of a conflict between the auditor and the client. The subjects

were paired up where one subject was asked to role-play as the auditor and the other was

asked to role-play as the client. The pairs were provided with a case in which the

appropriate conclusion to the accounting issue in question could be resolved by using the

accounting standards they were provided with.

The experiment employed a 2 x 2 between-subjects design (Table 3-1). There were

two different units of observation: One was observation based on individual reports and

the other was observation of a pair of students. The dependent variable measured is the

binary outcome of the conflict resolution (0=INCOVME for client-favoring outcomes,

1=INVENTORY for auditor-favoring outcomes). One variable was the type of

standards. The standards manipulation involved the resolution of a conflicting

accounting issue by employing either rules- or principles-based standards. Pairs assigned

to the rules-based standard condition were provided with a case in which the ambiguous

accounting issue could be resolved by employing rules-based standards. Both the auditor

and the client were provided with rules-based GAAP that appropriately supported their

stance on the matter. Auditors were given an excerpt from SAB 101, Revenue

Recognition in Financial Statements (SEC, 1999), and clients were given an excerpt from

SFAS 45, Accountingfor Franchise Fee Revenue (FASB, 1981). Pairs in the principles-

based standard condition were provided with GAAP that was not rules-based. Auditors

were provided with standards from ARB 43, Restatement and Revision of Accounting

Research Bulletins (CAP, 1953), on inventory and clients were provided with standards









from SFAC 6, Elements ofFinancial Statements (FASB, 1985), on characteristics of

gains.

Table 3-1. 2x2 between subjects design and the number of pair-wise observations in each
cell
Familiarity
Unfamiliar Familiar Total
St s Principles 17 16 33
Standards
Rules 16 16 32
Total 33 32 65

The other manipulated variable was familiarity. This manipulation was achieved

by informing half the pairs to assume that they had known each other for at least five

years personally and professionally1 and the other half was asked to assume that this was

their first encounter with each other.2

Table 3-2 summarizes the experimental design, indicating how the "standard" and

the "familiarity" manipulations interact to determine the outcome of the resolution when

different types of standards are used (related to H1) at two levels of familiarity (related to

H2) during conflict resolution. When the participating pairs are in the rules-based

standards condition, familiarity between the subjects does not increase the likelihood that

the auditor will agree with the client's position. When the participating pairs are in the

principles-based standards condition, familiarity between the subjects increases the

likelihood that the auditor will agree with the client's position.




1 Familiar auditor instructions: Your meeting at the headquarters is scheduled with the CFO, whom you
have personally known for over five years. You have worked with him/her on four other engagements and
have found him/her to be both conscientious and cooperative. You have attended several social gatherings
together and have enjoyed each other's company. You both know that the two of you get along well.

2 Unfamiliar auditor instructions: Your meeting at the headquarters is scheduled with the CFO, who has
been with the company for some time and is known to be both conscientious and cooperative. You do not
personally know anything about him/her. This will be the first time that you will be meeting him/her in
person.









Subjects

The participants were students who were enrolled in Intermediate Financial

Accounting class and Professional Accounting Research class at Fisher School of

Accounting, University of Florida. The experiment was conducted at the beginning of

their classes. All those who were present at the beginning of the class participated in the

experiment. The total number of participants was 130 students (65 pairs of students),

with 50 students from two sections of the Professional Research class and 80 students

from three sections of the Financial Accounting class. The participants were all above

the age of 21 and were all classified as at least a junior in the program. The students from

the Professional Research class did not receive any compensation for participating in the

experiment. As for the students from the Financial Accounting class, the participation in

the experiment counted as an extra lab grade, which constituted less than 1% of the total

course grade. An additional variable was included in the statistical analysis to test if the

two levels of compensation had an effect on the reporting decision of the pairs.

Table 3-2. Experimental design and predictions.
Familiarity
Accounting Standard Unfamiliar Familiar
Rules-based
Auditor's position Inventory Adjustment Inventory Adjustment
Client's position Income Income

Principles-based
Auditor's position Inventory Adjustment Inventory Adjustment
Client's position Income Income

Procedure

The students were asked to get into groups of two and were told that they would be

role-playing as either the auditor or the chief financial officer (CFO) of a company. Each

pair was distributed different sets of instructions. The experiment comprised of two









parts. In the first part of the experiment, the auditors received a set of instructions

informing them about their role along with a description of the accounting issue that

needed to be resolved. Half the auditors were told that they were familiar with their

client-that they were friends with the CFO and also knew them professionally. The

other half was told that this would be the first time they would be interacting with their

client. Likewise, the CFOs received a set of instructions informing them about their role

along with a description of the problem. The familiarity manipulation was applied to the

clients same way as it was applied to the auditors.

The case was adapted from the Deloitte & Touche Trueblood Accounting &

Auditing Case Study Series. The accounting issue in question was the classification of

$1,000,000. This amount could either be reported as an adjustment to inventory in the

following period or as income for the current period. After reading the case, the

participants were asked to write down and hand in to the experimenter their personal

opinion as to how the issue should be resolved.

In the second part of the experiment, the standards manipulation was applied in

addition to the familiarity manipulation. The participants were provided with a second

set of instructions. Half the pairs received principles-based standards that supported their

arguments and the other half received rules-based standards. The auditors were told that

their subordinates' report indicated the appropriate treatment to be an adjustment to

inventory in the following period supported by the provided accounting standard. The

clients were told that for the company's tax purposes and in order to receive the bonus for

the current period, the amount in question should be reported as income. They were also

provided with appropriate accounting standards that supported their argument, albeit

different from the ones the auditors received. All standards provided to both auditors and









clients are part of current GAAP and no standards were made up to support their

arguments.

Each pair, consisting of an auditor and a client, was then asked to discuss the issue

between them based on the standards provided. Half the pairs discussed the issue solely

based on rules-based standards and the other half discussed the issue based on principles-

based standards. All pairs were told that the financial statements had to be published the

next day and they had to make a joint conclusion on the matter based on the information

they had.

The threat of litigation and the removal of the auditor from the current assignment

are two factors in prior literature that have been suggested to increase the likelihood that

the auditors will agree with their clients (Farmer et al., 1987). To remove the

confounding effects of these factors, the participants were informed that there was no

threat of litigation posed by either of the accounting treatments in question and that the

client could not fire the auditor.

At the end of their discussion, the participants were asked to individually report the

concluding reporting decision; whether the amount in question should be recorded as an

inventory adjustment or income. This response provided data to test H1. The

participants were also asked to rate how familiar they felt with each other on a ten-point

scale (l=total stranger to 10=extremely familiar). This response was used to check for

the manipulation of familiarity and was also used to test H2.

Materials

The case

The case is about a company that has entered an exclusive supply agreement with a

supplier concerned about enhanced price competition from its rivals. Initially, the









supplier offers to pay the company a nonrefundable amount of $1,000,000 in cash and

promises best prices over the next two years in exchange for the signing of the exclusive

supply agreement. In exchange, the company has no obligations to fulfill after signing

the contract. Even if they renege and decide to purchase from another supplier, they

would still be entitled to claim the $1,000,000. The company declines to receive the

$1,000,000 in cash and instead asks the supplier to issue a credit memo of $1,000,000

that could be applied towards future purchases. The underlying motive for this is to keep

their tax bill low for the period while increasing their net income (by recording a gain of

$1,000,000), which would entitle the managers to a generous bonus. The fiscal year ends

the day after they sign the contract. The accounting issue is whether to record the amount

in question as income for the period or whether to apply it whenever inventory is actually

purchased from the supplier.

"Familiarity" manipulation

The subjects were provided with a description of the role that they were asked to

play. Familiarity manipulation was based on the length of the relationship between the

auditor and the client. Those assigned to the "familiar" group were told that they had

known each other for five years personally and professionally. They were told that they

had worked together on other business engagements, attended social gatherings together,

had occasional barbeques with each other's families on Sundays. Those in the

"unfamiliar" group were told that this would be the first time that they would be meeting.

Both groups were told that they were with someone who was known to be both

conscientious and cooperative at work.









"Standards" manipulation

Rules-based standards. The auditors were provided with the following excerpt

from SAB 101, Revenue Recognition in Financial Statements (SEC, 1999), to convince

their client that the amount in question could not be recorded as income for the period

since the credit memo was inseparable from the purchase of inventory. Unless the client

purchased inventory, the credit memo was deemed worthless. There was no transaction

that actually took place with the signing of the contract. It was simply an executory

contract. The only way to disclose it would be in the footnotes to the financial

statements.

The staff states that revenue is realized or realizable and earned when all of the
following criteria are met:

Persuasive evidence of an arrangement exists [yes; an executive contract is in
effect],

Delivery has occurred or services have been rendered [no; inventory has notyet
been purchased],

The seller's price to the buyer is fixed or determinable [yes; $1,000,000 is fixed],

Collectibility is reasonably assured [yes].



Revenue may not be recognized before it is realized or realizable and earned. An
amount received is not deemed to be earned under GAAP solely because it is
nonrefundable... In some circumstances, the right, product, or service conveyed in
conjunction with the nonrefundable fee has no utility to the purchaser separate and
independent of the registrant's performance of the other elements of the
arrangement. Therefore, in the absence of the registrant's continuing involvement
under the arrangement, the customer would not have paid the fee.

The clients were provided with the following excerpt from SFAS 45, Accounting

for Franchise Fee Revenue (FASB, 1981), to justify the reason why they could report the

amount in question as income for the period. They argued that an analogy could be made









to franchise fee revenues since no articulate standards about the particular transaction in

question existed in current GAAP.

Franchise fee revenue from an individual franchise sale ordinarily shall be
recognized, with an appropriate provision for estimated uncollectible amounts,
when all material services or conditions relating to the sale have been substantially
performed or satisfied by the franchisor. Substantial performance for the franchisor
means that:

(a) the franchisor has no remaining obligation or intent--by agreement, trade
practice, or law to refund any cash received or forgive any unpaid notes or
receivables;

(b) substantially all of the initial services of the franchisor required by the franchise
agreement have been performed; and

(c) no other material conditions or obligations related to the determination of
substantial performance exist.

Principles-based standards. The auditors in this manipulation group were told

that the amount in question could only be applied to future purchases, which made it

inseparable from inventory and that the credit memo should be considered like a price

discount, which is not the same as income. When a price discount it received, the

inventory cost is adjusted to reflect the discounted cost. By analogy, the credit memo

should also offset inventory cost when the inventory is bought. Similarly, the credit

memo could also be viewed like a big coupon: unless they ordered inventory, it was

worthless. They were provided with the following excerpt from ARB 43, Restatement

and Revision of Accounting Research Bulletins (CAP, 1953), to help them argue their

position.

The term inventory is used herein to designate the aggregate of those items of
tangible personal property which (1) are held for sale in the ordinary course of
business, (2) are in process of production for such sale, or (3) are to be currently
consumed in the production of goods or services to be available for sale.

A major objective of accounting for inventories is the proper determination of
income through the process of matching appropriate costs against revenues.









The primary basis of accounting for inventories is cost, which has been defined
generally as the price paid or consideration given to acquire an asset. As applied to
inventories, cost means in principle the sum of the applicable expenditures and
charges directly or indirectly incurred in bringing an article to its existing condition
and location.

The clients in the principles-based standard manipulation group were told that the

receipt of the credit memo represents income in exchange for signing the exclusive

supply agreement. They were told that the credit memo, in substance, represents a gain

to the company because it increases net assets and arises from a peripheral transaction.

They were provided with the following excerpt from SFAC 6, Elements ofFinancial

Statements (FASB, 1985), to support their argument.

Gains are increases in equity (net assets) from peripheral or incidental transactions
of an entity and from all other transactions and other events and circumstances
affecting the entity except those that result from revenues or investments by
owners.

Results

Descriptive Statistics

There were a total of 65 pair-wise observations. The number of observations in

each cell is reported in Table 3-1.

The Joint Decision

In the first part of the experiment, the subjects were asked to report their personal

opinion as to how the issue should be resolved. They could report their decision as

adjustment to inventory, income, or undecided. Initially, 90% of the participants replied

that the issue should be resolved as an adjustment to inventory, whereas only 7% of the

participants thought it should be recorded as income. There was little difference in

personal opinions when compared across the two subsets of participants (Table 3-3, Panel

A).









In the second part of the experiment, after the subjects were asked to discuss the

issue with each other, they were once again asked to report their personal opinion as well

as the pair-wise resolution to the issue. This time 73% of participants reported that the

amount in question should be recorded as inventory adjustment whereas those who

thought it should be recorded as income rose to 22% (Table 3-3, Panel B). The

difference between the sub samples appeared to be greatest in this panel.

When the pair-wise conclusions were observed, 72% of the conclusions were

adjustments to inventory, whereas 28% were income (Table 3-3, Panel C).

Table 3-4 provides a graphical illustration of how the personal opinions of auditors

and the clients differed after the discussion. Overall, the percentage of auditors who

believe the issue should be recorded as income increased to 15% whereas the percentage

of clients who believe the issue should be recorded as income increased to 29%. 28% of

the pair-wise conclusions were income. It appears that the auditors chose to agree with

their clients despite their personal preferences. It seems that the outcome of the

resolution reflects the client's point of view rather than the auditor's.

The auditors (clients) in ACG 4133 were more (less) prone to lean towards the

clients' (auditors') side when compared to ACG 5816 observations (Table 3-4, Panels A

and B). Likewise, there were more pair-wise conclusions in favor of the client within the

ACG 4133 participants (Table 3-4, Panel C).

Manipulated Variables

The pair-wise conclusions were reported as inventory by 47 of the pairs and income

by 18 of the pairs out of a total of 65 pairs (Table 3-5). More than half the pairs that

concluded the outcome to be an adjustment to inventory were in the rules-based standards

manipulation whereas more than half the pairs that concluded the outcome to be income









were in the principles-based standards (Table 3-5, Figure 3-1). More specifically, 33% of

the conclusions in the principles-based group were reported as income compared to 22%

of the conclusions in the rules-based group, which suggests that discussing an ambiguous

issue based on principles-based standards increases the likelihood that the auditor will

agree with their client.

Familiarity did not seem to have an effect on how the issue was resolved when

compared based on only pair-wise conclusions (Table 3-6). The total number of reported

resolutions as income and as inventory was equally divided between the familiar and

unfamiliar groups (Table 3-6, Figure 3-2). However, when the total sample was split into

groups of INCOME and INVENTORY based on pair-wise conclusions, the type of

standard and familiarity appeared to interact (Tables 3-7 and 3-8, Figures 3-3 and 3-4).

Among the pairs with inventory conclusion, i.e., when the auditor's position was agreed

upon by the pair, more than half the pairs in the familiarity manipulation were in the

rules-based group (Table 3-7, Figure 3-3). On the other hand, among the pairs with

income conclusion, i.e., when the client's position was agreed upon by the pair, more

than half the pairs in the familiarity manipulation were in the principles-based group

(Table 3-8, Figure 3-4). The type of standard did not have an effect on the pair-wise

conclusions when the pairs were in the unfamiliar group. Only when the pairs were

assigned to the familiar group did the type of standard seem to have a differential effect

on the pair-wise conclusions.

Manipulation Check for Familiarity

The participants were asked to report how familiar they felt with their partner after

they had discussed the issue as a manipulation check for familiarity variable. The total

sample was split into sub samples based on the familiarity manipulation. A t-test







43


assuming unequal variances was conducted to see whether the mean difference in the

degree of familiarity reported by individuals (l=total stranger to 10=extremely familiar)

assigned to familiar and unfamiliar groups would be statistically different than zero.

Tables 3-9 and 3-10 indicate that the mean difference between the unfamiliar and the

familiar groups was significantly different than zero. The mean degree of familiarity

reported by those in the unfamiliar group based on a ten-point scale (l=total stranger to

10=extremely familiar) was 6.53 compared to 8.11 in the familiar group.

Table 3-3. Comparison of individual beliefs before and after the discussion with pair-
wise conclusions.
Panel A Panel B Panel C
Personal Reports of Participants Pair-wise Conclusions
-. -.- .Pair-wise Conclusions
Before Discussion After Discussion
Income Undecided Undecided Income
9% 31% Income 46% 27 7





)Inventory I inventory Inventory
900% 731% 723%

All Observations (n=130)
Income Undecided Income
87% 5% Income U38% 30 0%
262%



) n \ ,nvenory
inventory Inventy Inventory
88 7% 70 0% 70 0%

ACG 4133 (n=80)
Income Undecided ncUndecided Income






Inventory Inventory Inventory
920% 78 0% 76 0%

ACG 5816(n=50)








44



Table 3-4. Comparison of auditor and client beliefs with pair-wise conclusions.
Panel A Panel B Panel C
Personal Reports of Participants After Discussion
sPair-wise Conclusions
Auditors Clients


Income


Undecided
46%


Undecided


Income
29 2%


Inventory
800%


Inventory
723%


Inventory
662%


All Observations (n=130)


Undecided


Undecided


Income
32 5%


Inventory
775%


Inventory
70 0%


Inventory
625%


ACG 4133 (n=80)

Income Undecided Undecided Income
80% 80% Income 400 240%
Income 0%
24 0%





Inventory
Inventory Inventory 76 0%
84 0% 720%


ACG 5816 (n=50)


Table 3-5. Number (percentage) of observations in "standards" manipulation.
Standards

Principles Rules Total

Joint Inventory 22(34%) 25(38%) 47(72%)
Decision Income 11(17%) 7 (11%) 18 (28%)

Total 33 (51%) 32(49%) 65(100%)













22- *25
22 L


15

10 117


Principles


- Inventory
Income


Rules


Figure 3-1. "Standards" manipulation graph. The graph shows the effect of standards on
the joint decision.


Table 3-6. Number (percentage) of observations in "familiarity" manipulation.
Familiarity
Familiar Unfamiliar Total
Joint Inventory 24 (37%) 23 (35%) 47 (72%)
Decision Income 9 (14%) 9 (14%) 18(28%)
Total 33 (51%) 32(49%) 65 (100%)


24- -. -. 23


- Inventory
-Income


9 9


Unfamiliar


Familiar


Figure 3-2. "Familiarity" manipulation graph. The graph shows the effect of familiarity
on the joint decision.









Table 3-7. Number (percentage) of observations when the joint decision is
INVENTORY.


Principles
Standards R
Rules
Total


Familiarity
Unfamiliar
12 (26%)
12 (26%)
24 (51%)


Familiar
10(21%)
13 (28%)
23 (49%)


Total
22 (47%)
25 (53%)
47 (100%)


Table 3-8. Number (percentage) of observations when the joint decisions is INCOME.
Familiarity
Unfamiliar Familiar Total
Principles 5 (28%) 6 (33%) 11(61%)
Rules 4 (22%) 3 (17%) 7 (39%)
Total 9 (50%) 9 (50%) 18(100%)


121
ri


- Principles
Rules


Unfamiliar


Familiar


Figure 3-3. Graph of Table 3-7. Joint decision is INVENTORY.












5 6


4 3


Unfamiliar


- Principles
-Rules


Familiar


Figure 3-4. Graph of Table 3-8. Joint decision is INCOME.


Table 3-9. Manipulation check for the familiarity variable for individuals. The
differences between unfamiliar and familiar treatment groups, based on the
degree of familiarity reported by each participant (l=total stranger to
10=extremely familiar) were compared using a t-test.
Unfamiliar Familiar
Mean 6.53 8.11
Variance 5.08 5.44
Observations 66 64
Hypothesized Mean Difference 0
df 127
t Stat -3.92
P(T<=t) one-tail 0.000
P(T<=t) two-tail 0.000


Table 3-10. Manipulation check for the familiarity variable for paired individuals. The
differences between unfamiliar and familiar treatment groups, based on the
average degree of familiarity reported by each pair (l=total stranger to
10=extremely familiar) were compared using a t-test.
Unfamiliar Familiar
Mean 6.27 8.16
Variance 5.42 5.49
Observations 33 32
Hypothesized Mean Difference 0
df 63
t Stat -3.25
P(T<=t) one-tail 0.001
P(T<=t) two-tail 0.002









Additional Variable: Compensation/Class

The participants in the Intermediate Financial Accounting class (ACG 4133)

received a grade that contributed to less that 1% of their total course grade for

participating in the experiment whereas those students in the Professional Research class

(ACG 5816) did not receive any compensation for participation. An additional binary

variable for compensation was included in the statistical analysis to control for any

differential effects this may have on pair-wise conclusions. However, the compensation

variable is confounded with the participant's class. The experiment setup fails to

differentiate the effects of compensation from the effects of being enrolled in a different

class.

Hypothesis Tests

The participants' individual reports and pair-wise conclusions were separately

analyzed using logistic regression with pair-wise conclusions (1=INVENTORY and

0=INCOME) as the binary dependent variable and the factors familiarity, standards, and

compensation as the independent variables. All the interaction variables were included in

the initial analysis. The pair-wise analysis results were weaker across all variables, since

the sample size was reduced from 130 to 65 when the unit of observation is changed from

individual observation to pair-wise observation. The probability modeled by the

regression is based on the INCOME conclusion. The results of the logistic regression are

reported in Table 3-11.

The regression results indicate that the main effects of familiarity, standards, and

compensation are all significant at the individual observation based analysis. Same

analysis reveals significant two-way interactions between familiarity and standards,

familiarity and compensation, and a borderline significant three-way interaction between









all three variables. When each class is analyzed separately using the same model, the

results continue to hold for ACG5816 students with regard to the main effects of

standards and familiarity, and the two-way interaction between the two, but not for

ACG4133 students (Table 3-11).

Table 3-11. Logistic regression model for single and pair-wise observations explaining
pair-wise conclusions.


Intercept

Familiarity

Standards

Compensation

Familiarity5 x Standards6

Familiarity x
Compensation
Standards x Compensation

Familiarity x Standards x
Compensation

Number of observations
-2 Log-likelihood statistic
Within-sample
classification rate3


Pair-wise Observationsb
Hypothesized Sign Full Samplel ACG 58162 ACG 41332
? 4.8832 4.8835 -1.1938
(0.1323) (0.1323) (0.5423)
+ -0.8698 -0.8699 0.1026
(0.0397) (0.0397) (0.3386)
-6.9507 -6.9511 -1.3827
(0.0289) (0.0289) (0.3262)
? -6.0770
(0.1088)
? 1.0261 1.0262 0.0519
(0.0625) (0.0625) (0.8917)
? 0.9724
(0.0791)
? 5.5679
(0.2442)
? -0.9742
(0.1460)


65
68.702


64.6


25
22.237

68


40
46.465

62.5


Paired rank correlation ("c"
statistic)4 0.692 0.763 0.649
* a Data collected based on individual observations was used to run the logistic
regression.
* b Data collected based on pair-wise observations was used to run the logistic
regression.
1 The analysis was run for the full sample with the pair-wise conclusion
(INVENTORY and INCOME) as the binary dependent variable. The probability
modeled by the regression is based on the INCOME conclusion. Reported values
are parameter estimates from Logistic Regressions with values of Wald chi-
squared statistics in parentheses. Reported p values for familiarity and standards
variables are one-tailed. All other reported p values are two-tailed.









* 2 The analysis was conducted separately for each sub-sample with the pair-wise
conclusion (INVENTORY and INCOVME) as the binary dependent variable. The
probability modeled by the regressions is based on the INCOVME conclusion.
Reported values are parameter estimates from Logistic Regressions with values
of Wald chi-squared statistics in parentheses.
* 3 This measure is a within-sample classification where each observation is
classified as an event or non-event based on the predicted probability from the
logistic regression and then compared to what actually happens in the event status.
* 4 This measure compares all possible pairs of observations with different responses.
It is said to be concordant (discordant) if the observation with the higher response
has a higher (lower) predicted probability than the lower level response. It is
closest to a goodness-of-fit test.
* 5 Familiarity variable is a subjective measure of how familiar the participants felt
with their partner and is included in the analysis conducted at the individual
observation level. A new familiarity variable is calculated as the average of the
subjective measures reported by the participants in each pair and is included in the
analysis conducted at the pair-wise observation level. The familiarity variable is
measured on a ten-point scale (1=total stranger to 10=extremely familiar).
* 6 Compensation variable is a binary measure coded as 1 for those participants in
ACG4133 and coded as 0 for those participants in ACG5816.
* 7 Standards variable is a binary measure coded as 1 for Rules-based standards and
coded as 0 for Principles-based standards.


The first hypothesis (H1) is that the likelihood that a client agrees with an auditor's

position increases when the auditor and the client resolve the issue using rules- rather

than principles-based standards. The descriptive statistics in Table 3-5 and Figure 3-1

indicate that this relationship appears to hold. The main effect for standards was

statistically significant, thus providing strong support for H1. H1 is a one-directional test;

therefore the reported p-values for standards variable are one-tailed.

The analysis at each sub sample level reveals that the results for ACG 5816

participants continue to be statistically significant for standards. For ACG 4133, the

main effect of standards becomes statistically insignificant, even though the parameter

estimate's sign is still in the same direction as the hypothesized sign.

The familiarity variable is defined differently at individual and pair-wise level

analysis. The logistic regression conducted at the individual level employed the degree









of familiarity reported by each participant as the familiarity variable. The same analysis

conducted at the pair-wise level employed the average degree of familiarity-calculated

as the average degree of familiarity reported by subjects in the same pair-as the

familiarity variable in the analysis.

The second hypothesis (H2) is that the more familiar an auditor is with a client, the

more likely s/he is to agree with a client's positions. An inspection of the graphs in

Figure 3-3 and Figure 3-4 indicates conflicting results and suggests an interaction

between familiarity and standards. The main effect for familiarity in the logistic

regression (Table 3-11) is statistically significant; however the sign is in the opposite

direction from the hypothesized sign. Thus, the regression results suggest that a higher

degree of familiarity reduces the likelihood of a client-favoring outcome. This result may

be due to the fact that all participants were accounting students and even though they

were asked to play the role of the manager, they probably intrinsically reasoned with the

mind of an auditor. Thus, the more familiar the pair was, the stronger was the intrinsic

motivation to favor the auditor's and not the manager's position. H2 is a one-directional

test; therefore the reported p-values for familiarity are one-tailed.

The analysis at each sub sample level reveals that the results for ACG 5816

participants continue to be statistically significant for familiarity, but still in the opposite

direction from the hypothesized sign. For ACG 4133, the main effect of familiarity

becomes statistically insignificant, but the parameter estimate's sign switches in the

direction of the hypothesized sign.

The significant interaction that is observed in the full logistic regression model was

further analyzed by splitting the sample into familiarity groups (Table 3-12). The logistic

regression based on pair-wise observations did not reveal any significant results. Thus,









the results for pair-wise analysis are not included. The interaction coefficient for

standards and compensation was insignificant, thus the data was not further analyzed at

class levels. The simple effect test for standards reveals at borderline significance that

when the auditor and the client are familiar with each other, discussing the ambiguous

issue using rules-based (principles-based) standards decreases the likelihood of a client-

favoring (auditor-favoring) outcome. This relation can be graphically observed in Figure

3-3 and Figure 3-4. On the other hand, when the auditor and the client were unfamiliar

with each other, discussing the ambiguous issue using rules- or principles-based

standards did not have any impact on the outcome of the resolution.

The logistic regression was conducted using sex, age, and academic level in the

program entering as independent variables. None of these additional variables had an

impact on the pair-wise conclusions. Thus, these results are not reported.

Discussion and Limitations

Results Discussion

The analysis conducted at two sub sample of classes show considerable differences.

A number of explanations can be enumerated for these differences. First of all, the

differences in results may be attributed to the compensation provided for participating in

the experiment to only one of the groups. Given the insignificance of the majority of

results for this compensated group, it appears that providing compensation randomized

the data. This view is not consistent with the idea of providing compensation in the first

place. Thus, there must be some other reason to explain the insignificant results in one

group and significant results in the other group. A plausible explanation is accounting

knowledge of students. ACG 5816 students have already taken ACG 4133 as a

prerequisite for enrolling in ACG5816. Thus, their accounting knowledge base can be









considered greater than those enrolled in ACG4133. Johnstone, Bedard, and Biggs

(2002) suggest that higher task knowledge auditors may be better prepared to interact

with aggressive, uncooperative clients. They show that inherited alternatives prohibit

generation of alternative solutions among lower knowledge auditors. This may very well

explain the discrepancy of outcomes between the two groups of students.

Table 3-12. Logistic regression for simple effects test for familiarity using data collected
at individual level.
Familiarity Treatment
Hypothesized Sign With Interaction Simple Effects2
Intercept ? -0.5108 -0.5108
(0.1618) (0.1618)
Standards -1.0986 -0.9555
(0.0998) (0.1005)
Standards x Compensation6 ? 0.2231
(0.8153)


Number of observations
-2 Log-likelihood statistic
Within-sample
classification rate3
Paired rank correlation ("c"
statistic)4


64
73.170

71.9

0.621


64
73.225

71.9

0.616


H


ypothesized Sign


Intercept ?

Standards

Standards x Compensation6 ?


Number of observations
-2 Log-likelihood statistic
Within-sample
classification rate3
Paired rank correlation ("c"
statistic)4


Unfamiliarity Treatment
With Interaction Simple Effects
-0.8755 -0.8755
(0.0200) (0.0200)
0.1823 -0.2231
(0.7998) (0.6878)
-0.6931
(0.4032)


66
76.487

72.7

0.565


66
77.184

72.7

0.528









1 The analysis was run for the full sample with the pair-wise conclusion
(INVENTORY and INCOME) as the binary dependent variable splitting on
familiarity. The probability modeled by the regression is based on the INCOME
conclusion. Reported values are parameter estimates from Logistic Regressions
and those in parentheses are one-tailed p values for standards and two-tailed p
values for other parameter estimates of Wald chi-squared statistics.
* 2 The analysis was run for the full sample with the pair-wise conclusion
(INVENTORY and INCOME) as the binary dependent variable splitting on
familiarity to test for simple effects of standards. The probability modeled by the
regression is based on the INCOME conclusion. Reported values are parameter
estimates from Logistic Regressions with p values of Wald chi-squared statistics in
parentheses.
* 3 This measure is a within-sample classification where each observation is
classified as an event or non-event based on the predicted probability from the
logistic regression and then compared to what actually happens in the event status.
* 4 This measure compares all possible pairs of observations with different responses.
It is said to be concordant (discordant) if the observation with the higher response
has a higher (lower) predicted probability than the lower level response. It is
closest to a goodness-of-fit test.
* 5 Standards variable is a binary measure coded as 1 for Rules-based standards and
coded as 0 for Principles-based standards.
* 6 Compensation variable is a binary measure coded as 1 for those participants in
ACG4133 and coded as 0 for those participants in ACG5816.


Another factor that may have produced the differences in results is the level of

authority present in the classroom while the experiment was conducted. The professor

was personally present when the experiment was administered to ACG5816 students

whereas a teaching assistant, who was a graduate student, was initially present and then

left the classroom while the experiment was administered to ACG4133 students. This

could suggest that the students in ACG5816 (more knowledgeable compared to those in

ACG4133 and working under the presence of an authority-albeit without any

compensation for participation) took the experiment far more seriously than the other

group. One could possibly infer that the credibility of the results from ACG5816

students are further enhanced by these uncontrolled and unforeseen factors that existed at









the time the experiment was conducted. Interpreted this way, the data obtained from

ACG4133 students could be viewed as adding random noise to the analysis.

The comparison of individual beliefs with pair-wise conclusions (Figure 2 and

Figure 3) illustrate that the outcome of conflict resolution closely reflects the beliefs of

clients. This could mean that auditor independence is truly impossible (Bazerman,

Morgan, Loewenstein, 1997). This pattern clearly reflects Antle and Nalebuff's (1991)

claim that joint conclusions of auditor and client are always client-favored. Figure 2

shows that the initial beliefs of participants before they discuss the issue are not

associated with their privately reported beliefs and the outcome of the resolution after

they have discussed the issue. Gibbins et al. (2001) also reported that they found no

association between the reported initial beliefs of the parties and the contextual features,

when beliefs are considered very important in basic negotiation models.

Limitations

One major limitation of the experiment is that the selected sample was initially

biased towards the auditor-favored conclusion. This was because all participants were

accounting majors. Nonetheless, comparison of initial beliefs with pair-wise conclusions

still display differences, indicating that even asking accounting students to role-play as

clients has an impact on the outcome of the conflict resolution. However, because the

sample was initially biased towards one side, this naturally produced pair-wise

conclusions that were also biased towards the same side, weakening the statistical results.

The pairs were provided with only one accounting standard to defend their point of

view. In reality, a variety of accounting standards are used to justify a certain reporting

decision and this set of standards will include both rules- and principles-based standards.

Thus, the results of the experiment are not immediately generalizable to other settings.









An important factor to reflect upon is that the standard setting process is a process and

that standards are not a static set over time. "Significant efforts should be made to

continue progress in the development of objectives from this point on. The objectives of

financial statements are not and should not be static." (report of the Accounting

Objectives Study Group, 1973, p. 44).

Majority of the subjects in the experiment had been in the program long enough to

know most about everybody in their class. Hence, even though the familiarity

manipulation seems to have worked to a certain degree, the results should be interpreted

with caution. Instructing people to assume that they do not know somebody when they

actually do is tricky. This can possibly explain why there were no significant results

associated with the unfamiliar group.

A further limitation of the study is that the experimental design did not take into

consideration potentially important factors in negotiation such as the

bargaining/discussion strategies of subjects, first mover advantage, additional information

added into the setting by the participants, and the degree of effort each participant put

into the discussion.

In the real world, there are many other factors that enter a negotiation process, each

factor interacting to a certain degree with all the other factors. Even in this small study, it

was documented that most of the interactions between the variables were significant.

Hence, the results of this study should be taken with a grain of salt for the simple fact that

there are at least a dozen missing variables from the equation.














CHAPTER 4
CONCLUSION

The principle of conservatism is an important feature of the financial reporting

system. There have been numerous empirical attempts to measure the extent of

conservatism embedded in the financial statements. Chapter 2 discusses these different

measures and the results of the empirical studies in light of a simple model that attempts

to explain the conflicting results of balance sheet based and income statement based

conservatism measures. The model explains why increased income statement based

conservatism may be associated with decreased balance sheet based conservatism. I also

distinguish between growth and no-growth firms and argue that the difference between

the two measures cannot be interpreted adequately given increased growth. Additional

empirical analysis is needed to test the model. An empirical study can be conducted

using a proxy for growth and forming portfolios based on growth and then measuring the

degree of conservatism on the balance sheet and the income statement.

One very important conclusion that emerges from chapter 2 is that there is not a

single measure of conservatism. There are many factors to consider and any simplistic

way of attempting to measure conservatism cannot be relied upon to draw conclusions

about the degree of conservatism inherent in financial reporting. Other than quantitative

factors, there are qualitative factors that interfere when making decisions under

uncertainty. Prudence for example, a subjective concept, is deemed conservative

behavior (Giner and Rees, 2001). Thus, the "value" of an increment of prudence or the

level of prudence may differ greatly across companies and across countries.









Chapter 3 explores the effects of two qualitative factors that may influence

conservatism in financial reporting. A unique setting is chosen to explore how the

resolution of an ambiguous accounting issue between the auditor and the client can be

affected by employing different types of standards and whether the degree of familiarity

between the auditor and the client impacts the outcome of the resolution. The

experimental design is based on the three-element process model of auditor-client

accounting negotiation proposed by Gibbins et al. (2001). The results indicate that the

type of standards and the degree of familiarity jointly have an effect on conflict

resolution. Thus, the joint decision of two parties that have a conflict of interest will

ultimately affect the degree of conservatism in the reported numbers.

Hence, conservatism is an elusive concept difficult to operationalize with simple

quantitative measures that lack contextual factors. Any empirical studies that claim to

report on the degree of conservatism in financial reporting have to be analyzed and

interpreted with great caution before drawing conclusions.














APPENDIX
HISTORICAL PERSPECTIVE ON THE DEVELOPMENT OF ACCOUNTING
STANDARDS

1929 Market Crash and the Development of Accounting Standards

The Securities and Exchange Commission (SEC) was formed to restore public

confidence in the capital markets after the stock market crash in 1929. The main purpose

of the SEC was to build investors' trust by ensuring that the companies truthfully

conveyed information about themselves to the public

[http://www.sec.gov/about/whatwedo.shtml]. The only way this could be done and

monitored at the same time was creating regulations that would make the companies

report truthfully. Regulation is possible through the formation of a police force of some

kind that will enforce a set of rules. The SEC would be the police force and the set of

rules needed to be created. At the time, accounting standards were not heard of, so the

SEC encouraged the creation of a group of standard setters. In recognition of the

resources, expertise, and talent of the private sector, the SEC supported the formation of a

private standard-setting body and asked the American Institute of Accountants (later

AICPA) to undertake the task of providing accounting standards for companies (Kieso,

Weygandt, and Warfield, 2001).

The AICPA appointed a small group of prominent academics, Sanders, Hatfield,

and Moore, to write the accounting standards and published their work in 1938: A

Statement ofAccounting Principles, which is the first noteworthy book of accounting

standards. In the Introduction section of the book, the authors stated that several

institutions had already issued various sets of accounting standards. For example, the

59









AICPA had published a brief statement of principles, the SEC had issued accounting

regulations for the administration of the legislation, and the Bureau of Internal Revenue

had enlarged the volume of its accounting rules for determining taxable income.

However, none of the issued statements represented a complete formulation of

accounting principles. It seemed that each agency was stating only those accounting

rules that required compliance with the statutes it was administering. Thus, the time

seemed ripe for the compilation of a comprehensive statement of accounting principles.

The authors, not being members of the AICPA but notable academics, had been asked to

carry out the task of writing the standards on behalf of the Institute yet independently

from the Institute. This appeared to be a perfect arrangement for the AICPA: it

encouraged research without lending authority to its findings. On the other hand, the

SEC was not satisfied with the arrangement and urged the Institute to back their findings

and endorse their principles, which led to the formation of the Committee on Accounting

Procedure (CAP) in 1939 (Baxter, 1979).

CAP issued 51 authoritative standards known as Accounting Research Bulletins

(ARB) from 1939 to 1959. ARBs were issued in response to accounting problems

occurring at the time. The ARBs had a big impact on the financial reporting system and

constituted the basis of generally accepted accounting principles (GAAP), but the

problem-by-problem approach to formulating standards failed to provide the desired

structured body of accounting standards (Kieso et. al, 2001). All CAP members worked

part-time. There was not enough staff and the turnover ratio was high. The critics

pointed out that the committee did not rely enough on research and that it was the

catspaw of the SEC. Thus, came the demise of CAP and the formation of a new

committee: the Accounting Principles Board (Baxter, 1979).









The Accounting Principles Board (APB), run by about 20 part-time members,

replaced CAP in 1959. After a decade of its formation, criticisms began to pour in once

more: APB was considered to be lacking the resources necessary to develop high-quality

standards to meet the increasingly complex business transactions of the times

[http://www.aicpa.org/info/regulation02.htm]. The development of a conceptual

framework was a principal part of the charter of the APB in 1958 (Burton, 1978). Yet,

there were complaints about the lack of articulated statements of basic concepts

underlying procedures that would enable uniformity, simplicity, and comparability in

financial reporting. There was a "longing for certainty" that could only be provided by a

coordinated system of principles (Davidson, 1969). APB's failure to provide such a

conceptual framework has been cited as one of the main reasons that eventually led to its

replacement by the Financial Accounting Standards Board (FASB) in 1973 (Burton,

1978). By the time APB was terminated, it had issued 31 standards called APB

Opinions.

Blue Monday and the Emerging FASB

Trueblood (1970) observed that there were "rising expectations" in all fields

including accounting mostly because of the advances in technology and communications

at the time. He pointed out that increased personal and social choices, business

alternatives, interdependence, and the rising costs accompanying the choices would likely

intensify the moral and ethical problems that already existed in the accounting profession.

He called for "rules for the profession" so that the accountants could not find ways to

circumvent APB Opinions that their clients did not like. He stated that the "profession

must move to correct deficiencies in the setting of standards with more alacrity than it has

so far seemed able to muster" (p. 38).









Trueblood's observations and recommendations for the accounting profession

closely follow the market crash of 1969. In 1971, in the aftermath of the crash, the

AICPA appointed a Study Group on Establishment of Accounting Principles (commonly

known as the Wheat Committee). This was an action similar to the one that AICPA

undertook after the 1929 crash when the AICPA appointed academics to write standards

on behalf of the Institute. The Study Group's recommendations were submitted to the

AICPA Council in 1972, adopted in total, and shortly after implemented in 1973. As a

result of the Wheat Committee's recommendations, the APB was disbanded and the

FASB was founded (Kieso et. al, 2001).

The Study Group's conclusions were based upon the fundamental concept that

financial statements should aid economic decision-making. All the major conclusions of

the Group aimed for a "principles-based" approach to standard setting. "Emphasize

substance, not technical form" was explicitly listed as one of the conclusions (Report of

the Accounting Objectives Study Group, 1973). Hence, the Wheat Committee initially

started out with a principles-based approach to standard setting just like all the previous

committees that undertook the task.

The FASB started its operations by implementing the Trueblood report and

formulating a conceptual framework for the profession, which the CAP and the APB had

failed to do. This conceptual framework would provide the basis upon which new

standards could be issued (Flegm, 1989). Flegm (1989) described the FASB's next

decade full of tension but nonetheless revolutionary as the committee proceeded on the

conceptual framework project. The Discussion Memorandum (DM) published in 1976

supported a shift from the matching of costs and revenues perspective to an asset/liability









view when determining income. Two public hearings were held in 1977 and 1978 to

discuss the DM and the perceived shift in income determination.

In 1978, Flegm (1989) attended a special meeting of the FASB on the conceptual

framework project and the DM. The meeting entailed the discussion of "eight examples

of accounting problems ... with the participants being asked to1 comment on whether or

not they accepted the various alternatives under the asset/liability or revenue/expense2

view. Without delving extensively into the discussion, it is fair to say that there was little

consensus on any of the issues" (p. 91). The author stated that despite the lack of

consensus, the FASB was determined to implement the Trueblood report, which was

geared toward the asset/liability view of income and entailed the prediction of future cash

flows and fair value accounting. On the other hand, accountants led by Financial

Executives Institute's (FEI) Committee on Corporate Reporting, argued for the

maintenance of the historical-cost based accounting and the retention of the matching

concept (p. 91). Flegm pointed out that this fundamental argument had not been resolved

when the concepts statements were being developed, which eventually led to so many

compromises that in the end no one has been satisfied with the result.

To assist the FASB in the development of a conceptual framework, the AICPA,

Financial Analysts Federation, FEI, and the Robert Morris Associates got together to

discuss the issue in the triennial Seaview Symposium (Burton, 1978). The group shared

the general view that financial statements should be limited to objectively verifiable data



1 Asset/liability perspective considers assets and liabilities to be direct measurements of economic
phenomena and defines income as a change in such phenomena. This view endorses the fair-value
approach to accounting (Burton, 1978).
2 Revenue/expense perspective considers assets and liabilities to be residuals arising out of the income
measurement process. This view endorses the historical cost approach to accounting (Burton, 1978).









and objectivity should not be compromised for better predictive information. However,

there were differences of opinion on how far the process of emphasizing objectivity

should go. Some supported the notion of moving towards a more cash-basis accounting,

whereas others, including the FASB, preferred an accrual-basis accounting but at the

same time were in favor of objective measurements that would minimize management's

role in income determination. The consensus was that the financial statements

themselves should not emphasize predictive data, yet a predictive approach to financial

reporting should be undertaken outside the financial statements to aid users of

information in decision-making about companies. The group proposed that predictive

data, subject to uncertainties and differences in subjective opinion, should appear under a

separate section of the financial report and not be audited as rigorously as the financial

statements. This way the statements would be simpler, more uniform, more

understandable and less subject to manipulation. A small group was concerned because

of added constraints to the conceptual framework project and objected to an

implementation of the dual reporting approach. (Burton, 1978).

1980s: How (and Why) did We Move Away from 'Principles-Based' Approach to
Standard Setting toward a 'Rules-Based' Approach?

In the 1980s, the search for a conceptual framework to guide the FASB in decision

making was still a lingering issue. Accounting Principles Board Statement no. 4, Basic

Concepts and Accounting Principles Underlying Financial Statements of Business

Enterprises, was perceived as helpful in defining objectives, but nevertheless considered

insufficient in prescribing a clear direction for standard setting (Kirk, 1981).

Horngren (1981) observed that the FASB was moving in the direction of building a

conceptual framework that emphasized the technology of accounting. He explained that









this was because of a "problem of social choice." A technical framework would empower

the FASB by "measuring the financial impact of events in an evenhanded manner" and

thus steer the board away from the "problem of social choice." For the FASB, this

"problem" entailed the identification of the constituencies in power, acting in accordance

with their wishes and accomplishing this in a manner that would be acceptable by "the

800-pound gorilla in the form of the federal government, particularly the SEC" in order

to ensure its survival. The emphasis on certain issues would still continue to depend on

the relative importance of the board's constituencies, but building a more technical

framework would enable the FASB to stay away from the policymaking process

(Horngren, 1981, p. 88).

In the beginning of the 1980s, the accounting profession had already begun

complaining about a standards overload (Chenok et. al, 1980). Not heeding the protests

of the profession, the FASB embarked on a journey of moving away from "principles-

based" toward "rules-based" standards. The motivation behind this apparent course of

action was to empower the FASB help drive out "creative accounting" that emerged as

executive pays were increasingly tied to reported profits and as new and riskier ways of

financing appeared as a result of globalization and deregulation (Piecara, 2002).

Sterling's captivating description of the accountant's dilemma (1973) closely

parallels the FASB's problem in the 1980s and why the board opted to move toward a

more "rules-based approach" to standard setting:

"As an independent auditor, the accountant needed a strong defense against the

always optimistic, sometimes dishonest, financiers and entrepreneurs. Unfortunately, he

was not given this defense. Instead, he was placed in the precarious position of being the

employee of the person he was obliged to keep honest. In the absence of a cohesive









theory, in the absence of police power, in the presence of ignorance and apathy of the

community, his only defense was precedent and persuasion. Precedent soon became rule

and the rigid application of rules was his primary weapon. It is much easier and more

diplomatic to accuse someone of breaking a rule than to accuse him of telling a lie" (p.

61).

"The Nature of Standards" in 1980s, EITF, and More "Rigid" Rules

The Emerging Issues Task Force (EITF) was established in 1984 upon the FASB's

recommendations to form a group responsible for timely financial reporting guidance in

order to assist with emerging accounting problems [http://www.fasb.org/eitf]. The task

force did not have any formal authority, yet its views quickly became to be regarded as

de facto GAAP for managers and accountants who wanted timely guidance on new issues

(Wishon, 1986). In less than two years time after its formation, the EITF fueled the

lively debate on whether standards should be "general" or "specific" (Wishon, 1986).

Despite advocates for broad and general standards, who believed detailed questions

should be dealt by managers, the task force's having reached a consensus on almost 50

issues in its first 20 months was clear evidence that those who supported detailed

standards had won the latest round on the long-debated issue (Wishon, 1986).

Black Monday and the Troubled FASB

There were major changes in the composition of the FASB right before the market

crash in 1987 (Flegm, 1989). The publication of a White Paper sponsored by the FEI and

the Accounting Principles Task Force suggested an increase in business-trained people on

the FASB and the trustees of the Financial Accounting Foundation (FAF), which was

followed by the appointment of Art Northrop and Vic Brown (both with primarily a

business background) to the FASB. This raised considerable controversy in the









accounting field with some believing it to be an attempt by business to "take over" the

standards-setting process. The resignation of Art Wyatt in mid-1987 because of the

increased influence of business in the FASB's activities was the ultimate peak of the

controversy. As the dispute subsided following the appointments of Jim Leisenring and

Clarence Sampson to the FASB, and by the time the virtual reformation of the Board was

complete in 1987, there was yet another market crash: the Black Monday. This time the

reformation of the standard-setting committee coincided with the collapse of the financial

market. Hence, this was the FASB's opportunity to start afresh with the financial market

in the aftermath of the crash.

The "Tech Bubble" and the Proposed Shift from "Rules-based" to "Principles-
based" Standards

History seems to repeat itself as we once again embark on a search to improve the

financial reporting system after yet another market crash: the "burst of the tech bubble".

The desirable shift is this time towards a more principles-based approach to accounting

standards as called forth by the Sarbanes-Oxley Act to which the FASB has responded by

issuing a "Proposal for a Principles-Based Approach to U.S. Standard Setting" (FASB

2002).
















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BIOGRAPHICAL SKETCH

I was born and raised in Adana, Turkey. I graduated from Bogazici University in

Istanbul, Turkey, with a Bachelor of Arts in business administration in June 1993. I

received a Master of Education in educational psychology from the University of Florida

in 2000. Currently, I am working towards a Master of Arts degree in economics.




Full Text

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CONSERVATISM IN ACCOUNTING: AN ANALYTIC EXPLANATION AND AN EXPL ORATION OF THE EFFECTS OF FAMILIARITY AND RULESVS. PRINCIPLES-BASED STANDARDS By IDIL RAIFE BURAT IMPINK A THESIS PRESENTED TO THE GRADUATE SCHOOL OF THE UNIVERSITY OF FLOR IDA IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS UNIVERSITY OF FLORIDA 2006

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Copyright 2006 by Idil Raife Burat Impink

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iii ACKNOWLEDGMENTS I am grateful to Gary McGill and Dominique DeSantiago for their unwavering support. They have been the most wonderful mentors, friends, a nd bosses I could ever wish for. I thank David Sappington and Steven Slutsky for their help in finalizing my degree. Finally, I thank my husband, Joost Impink, and my daughter, Selin Yaylali, for helping me understand what matters most in life.

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iv TABLE OF CONTENTS page ACKNOWLEDGMENTS.................................................................................................iii LIST OF TABLES.............................................................................................................vi LIST OF FIGURES..........................................................................................................vii ABSTRACT.....................................................................................................................viii CHAPTER 1 INTRODUCTION........................................................................................................1 2 CONSERVATISM PUZZLE.......................................................................................3 Measures of Conservatism............................................................................................6 Balance Sheet Conservatism.................................................................................7 Income Statement Conservatism...........................................................................8 Accruals Conservatism........................................................................................10 The Puzzling Evidence on Conservatism...................................................................12 The Model...................................................................................................................15 No Growth Case..................................................................................................16 Growth Case........................................................................................................20 3 THE EFFECTS OF RULESVS. PRINCIPLES-BASED STANDARDS AND FAMILIARITY..........................................................................................................23 Theoretical Basis for Experiment Design...................................................................25 Background and Hypotheses......................................................................................27 Rulesvs. Principles-Based Standards................................................................27 Familiarity...........................................................................................................31 Method........................................................................................................................32 Experimental Design...........................................................................................32 Subjects................................................................................................................34 Procedure.............................................................................................................34 Materials..............................................................................................................36 The case........................................................................................................36 Familiarity ma nipulation..........................................................................37 Standards manipulation............................................................................38

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v Results........................................................................................................................ .40 Descriptive Statistics...........................................................................................40 The Joint Decision...............................................................................................40 Manipulated Variables.........................................................................................41 Manipulation Check for Familiarity....................................................................42 Additional Variable: Compensation/Class.........................................................48 Hypothesis Tests..................................................................................................48 Discussion and Limitations.........................................................................................52 Results Discussion...............................................................................................52 Limitations...........................................................................................................55 4 CONCLUSION...........................................................................................................57 APPENDIX HISTORICAL PERSPECTIVE ON THE DEVELOPMENT OF ACCOUNTING STANDARDS............................................................................................................59 LIST OF REFERENCES...................................................................................................68 BIOGRAPHICAL SKETCH.............................................................................................74

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vi LIST OF TABLES Table page 3-1. 2x2 between subjects design and the number of pair-wise observations in each cell........................................................................................................................... .33 3-2. Experimental design and predictions.........................................................................34 3-3. Comparison of individual beliefs before and after the discussion with pair-wise conclusions...............................................................................................................43 3-4. Comparison of auditor and client beliefs with pair-wise conclusions.......................44 3-5. Number (percentage) of observa tions in standards manipulation..........................44 3-6. Number (percentage) of observa tions in familiarity manipulation........................45 3-7. Number (percentage) of observations when the joint decision is INVENTORY.....46 3-8. Number (percentage) of observations when the joint decisions is INCOME...........46 3-9. Manipulation check for the fam iliarity variable for individuals................................47 3-10. Manipulation check for the familiar ity variable for paired individuals...................47 3-11. Logistic regression model for single and pair-wise observati ons explaining pairwise conclusions.......................................................................................................49 3-12. Logistic regression for simple effects test for familiarity using data collected at individual level.........................................................................................................53

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vii LIST OF FIGURES Figure page 2-1. Graph of earnings regressed on positive and negative returns.....................................9 2-2. Cumulative accruals by type.......................................................................................11 3-1. Standards manipulation graph................................................................................45 3-2. Familiarity manipulation graph..............................................................................45 3-3. Graph of Table 3-7....................................................................................................46 3-4. Graph of Table 3-8....................................................................................................47

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viii Abstract of Thesis Presen ted to the Graduate School of the University of Florida in Partial Fulfillment of the Requirements for the Degree of Master of Arts CONSERVATISM IN ACCOUNTING: AN ANALYTIC EXPLANATION AND AN EXPL ORATION OF THE EFFECTS OF FAMILIARITY AND RULESVS. PRINCIPLES-BASED STANDARDS By Idil Raife Burat Impink May 2006 Chair: David Sappington Major Department: Economics The principle of conservatism is a ma jor feature embedded in the financial reporting system. Recently, there have been numerous empirical attempts to measure the extent of conservatism that exists across firm s and countries. The results of the empirical studies based on different measures of conser vatism are conflicting. This study explores the principle of conservatism from an alytic and behavioral perspectives. The analytic section of this study attempts to unravel the conf licting results of the archival studies and questions the extent to which accounting c onservatism can be measured empirically. The results of the an alytic study show that a single measure of conservatism does not exist and empirical studies that employ a single measure of conservatism can not be relied upon to draw conclusions ab out the degree of conservatism inherent in financial reporting. In addition to quantitative fact ors, qualitative factors also need to be considered in determining the degree of conservatism when decisions are made under uncertainty or

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ix when decisions are made between parties that have a conflict of interest. The behavioral section of this study explores two factors th at may influence the degree of conservatism that is observed in financial re porting. Specifically, th is part explores th e effects of rulesvs. principles-based accounting standards and the influence of familiarity on conflict resolution when auditors and their client s collectively decide on how an ambiguous accounting issue should be reported in the fi nancial statements. The results of the experiment indicate that the type of standard s and the degree of familiarity jointly have an effect on the degree of conservatism inhe rent in the reported numbers. This is important in showing how quantitative measures are affected by qualitative factors that surround the decision making process.

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1 CHAPTER 1 INTRODUCTION Accounting conservatism is a major feature of the financial reporting system. The saying anticipate no profits and provide fo r all possible losses (Devine, 1963; Watts, 2003a) describes conservative reporting on the income statement, which has inspired most of the recent empirical research on c onservatism (Ball, Kothari, and Robin, 2000; Basu, 1997; Givoly and Hayn, 2000; Holthausen and Watts, 2001). The most commonly used measures of cons ervatism in the literature are income statement based as derived by Basu (1997), and balance sheet based assessments as captured by the market-to-book ratio. The resu lts of the empirical studies based on these measures are conflicting. In chapter 2, I attempt to unravel the conf licting results in the empirical literature and I question the extent to which accounting conservatism can be accurately measured. The results in chapter 2 indicate that c onservatism can not be measured by a single measure and that other factors may influen ce the conservatism in reported numbers. I further explore the idea that qualitative factors may have an influence on the degree of conservatism in financial reporting. In chapter 3, I explore this idea through an experiment that examines two factors that may affect the joint decision of two parties that have a conflict of interest. The auditor and the client are a classic example of two parties known for their inherent conflict of interest. The client pays the a uditor for auditing its financial statements. Thus, the auditor can do a satisfactory job in the ey es of the client if the auditor issues an opinion in line with the clients. Th e outcome of the joint decision

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2 process reflects the degree of conservatism inherent in financia l reporting. The results in chapter 3 indicate that familiarity and the type of standards may jointly affect the outcome of a joint d ecision making process. Chapter 4 concludes the findings of the study.

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3 CHAPTER 2 CONSERVATISM PUZZLE The Financial Accounting Standards Bo ard (FASB) Statement of Financial Accounting Concepts (SFAC) No. 2 (1980) de scribes conservatism as the understatement of net income and net assets in the pr esence of uncertainty. This description encompasses conservatism as it is reflected on both the balance sheet and the income statement. However, this does not imply that the effects of understatement will impact both statements equally. Basu ( 2001) gives the following example: It is useful to distinguish between the balance sheet and income statement effects of conservatism, since they do not alwa ys go hand in hand. The purchase and pooling-of-interest methods of accounting for mergers under U.S. GAAP provide a useful illustration. Under the pooling-of-interest method, the acquired firms assets and liabilities are reported on the acquirer s balance sheet at the values on the acquired firms balance sheet, and deprec iation typically continues under the preexisting basis. Under purchase accounting, th e assets and liabili ties of the acquired firm are reported on the acquirers balance sh eet at fair values, which are typically greater than their values reported on the ac quired firms balance sheet. However, these assets are subsequently depreciate d and/or amortized at rates higher than those previously used by the acquired fi rm. Thus, the pooling method results in more conservative balance sheets and less conservative income statements than the purchase method, at least under the traditional definition. (p. 1335) The reason why the effects of conservatis m manifest in varying degrees in the financial statements may be due to the fact that the conservatism principle overlaps the two primary qualities of the financial statements : relevance and reliability. Relevance is achieved through information that has predictive value, feedback value and that is timely. Reliability is achieved through representational faithfulness, verifiab ility and neutrality (SFAC No. 2). There exists a tradeoff between relevance and reliability: more relevance can be achieved at the expens e of reliability. Barth, Beaver, and Landsman (2001) state

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4 that conservatism can be a by-product of appl ying the FASBs reliab ility criterion (p. 94). However, while on the one hand th e conservatism principle requires more verifiability for reporting good news, on th e other hand the use of conservatism in making judgments under conditions of uncertain ty deters the neutrality of financial statements. In addition to the statement in Barth et al., conservatism can also be a byproduct of the relevance criteri on as it requires predictive valu e, feedback value, and the timely recognition of bad news in the fi nancial statementsbut not good news. Thus, the concept of conservatism nurtures bot h of the primary qualities of the financial statements in an asymmetric manner. Kieso, Weygandt, and Warfield (2001) label conservatism as one of the overriding constraints to the qualitative characteristics, which introduces yet another an gle to the conceptualization. Moreover, income statement and balance sheet conservatism may be applied at varying degrees because of the different func tions they serve. There may be different forces at work pushing in opposite directions: more aggressive on the income statement (as aggressive as possible that is allo wed by the accounting st andards) and more conservative on the balance sheet (as conser vative as possible that is allowed by the accounting standards). For example, assumi ng that earnings provides a performance measure for compensation contracting and m onitoring purposes while the balance sheet provides an estimate of the liquidation value of net assets for borrowing purposes, it is understandable that income statements will be used by managers in a least conservative manner whereas balance sheets will tend to er r towards the more conservative end. The empirical evidence collected based on operationalized definitions of conservatism measures indicate s that accounting practice has become more conservative in the last 30 years (Basu, 1997; Givoly and Hayn, 2000; Watts, 2003b). Has accounting

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5 really become more conservative in the past three decades? One of the most commonly cited reasons for this increased degree of conservatism is the litigious environment that was created after the 1966 changes in the ru les of bringing class action suits (Watts, 2003a). The fear of litigation has supposedly forced accounting reporting to become more conservative. Yet, could it be that litigation has increased because of aggressive financial reporting and this ha s not necessarily made companies more conservative, but in fact more calculative? Could there have been other changes at work that forced litigations to increase? An answer may be derived from Zeffs (2003a) review of the accounting profession during the 20th century. According to Zeff ( 2003a), one major change that has affected the large accounting firms in the last 30 years was the growth of consulting services, which eventually led to the accounting prof ession succumbing to the mentality of making profits. In addition to this organizational change taking place within accounting firms, financial reporting norms we re also under stress during the 1980s as (1) industry regulators increasingly viewed them as a means to achieving public interest goals (e.g., regulators in the banking and thrift industries pressuring the FASB and the audit firms to use deceptive accounting practi ces in order to rescue failing banks and savings and loan institutions in the name of the public interest) and (2) firms and trade associations demanded more preparer-friendl y standards from the FASB (Zeff, 2003a). Furthermore, the 1980s was also the decade when analysts earnings forecasts became more prominent, which created increased pre ssure on CEOs to achieve earnings targets. These developments led towards a more assertive and aggressive accounting practice as auditors felt pressure from both inside and outside the accounting firm: on the one hand companies wanting to secure auditor approval for creative accounting

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6 techniques, and on the other hand the accounting firms wanting to keep the clients business. The accountants role diminished to one of putting the f oot in the clients door and once through the door, keeping the cl ient happy. Not surprisingly, by the mid1980s all of the booklets and newsletters pr eviously published by the large accounting firms expressing views on controversial i ssues became nonexistent, which marks the death of the accounting profession as it was known before (Zeff, 2003b). The empirical research based on the opera tionalized definition of conservatism hypothesizes that the most important explana tions to conservatism are contracting and shareholder litigation (Watts, 2003a). Howe ver, Begley and Freedmans (2004) study provide evidence on the contra ry. They investigate the changing role of accounting numbers in public lending agreements and show th at there is a dramatic decline in the use of accounting numbers over the la st quarter century. In th e late 1970s, accounting-based restrictions on dividends and additional borrowing appear in almost half of the debt issues examined, in the 1990s the use of accounting-based restrictions falls down to 25 percent and in the 1999-2000 samp le down to less than 10 percent. In the light of empirical research on conservatism, which pr ovides evidence that accounting practice has become more conservative in the last 30 years because of contracting purposes, the results of Begley and Freedman are puzzling. Measures of Conservatism Researchers have used various measures to gauge conservatism in financial statements. These measures have been deri ved from three major accounting numbers: net assets, earnings, and accruals (Watts, 2003b ). Following is a description of each of these measures labeled as balance sheet c onservatism (utilizing net assets), income

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7 statement conservatism (utilizing earnings ), and accruals conservatism (utilizing accruals). Balance Sheet Conservatism Balance sheet conservatism describes the choice of accounting methods and estimates that keep the book values of ne t assets relatively low (Penman and Zhang, 2002). For example, LIFO accounting for invent ories is conservative relative to FIFO; accelerated depreciation for property, plant, and equipment is conservative relative to straight-line deprecia tion; and expensing research a nd development (R&D) expenditures is conservative compared to capitalizing thes e expenditures. One empirical measure of conservatism emanates from the work of Feltham and Ohlson (1995), who model the relation between a firms market value and accounting data. They distinguish between unbiased accounting and conservative accounting in terms of how book value differs from market value. Based on Feltham and Ohlsons work, Zhang (2000) gives the following definition of conservatism: An accounting policy is conservative if lim[]/[]1ttttEoaEV (Eq. 1) where oa is operating assets and V is the market value of ope rating assets. The marketto-book ratio has been used as a proxy for balance sheet conservatism based on this relationship (e.g., Givoly and Ha yn, 2000; Lara and Mora, 2004). This implies that the market-to-book ratio will be greater than one if companies are conservative on their balance sheets. The source of understatement of the book va lue relative to the economic value can be due to: (1) the failure to capture the positive net present value of projects and subsequent increases in value; (2) the minimi zation of the carrying va lue of net assets in place; and (3) the prompt r ecognition of losses (Givoly, Hayn, and Natarajan, 2003). The

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8 source of understatement that is due to the fa ilure to capture the pos itive net present value of projects and subsequent in creases in value introduces the growth factor into the market-to-book ratio. In fact market-to-book ratios have been widely used to proxy for growth in the financial literature where hi gh (low) market-to-book ratio firms have been described as growth (value) firms (Breale y, Myers, and Marcus, 2001; Fama and French, 1995, 1998). Thus, high market-to-book ratios can be an indicator of conservative accounting practices on the balance sheet and/or high growth firms. The interaction of accounting bias with growth is a well-known fact (Beaver and Ryan, 2000). Thus, at this point, it becomes difficult to tease apart the conservatism embedded in the balance sheet and the growth potential that is perceive d by the market. Indeed, Penman and Zhang (2002) state that this interact ion of growth and conservatism the joint effect of real activity and accounting policy (p. 238) can be used to manage earnings. Income Statement Conservatism Recently, Basu (1997) introduced a measure of conservatism that uses earnings and stock returns to capture the conservatism principle implied by the adage anticipate no profits and provide for all the losses. He interprets conservatism as capturing accountants tendency to require a higher de gree of verification for recognizing good news than bad news in financial statements (p. 4). The measure of conservatism is derived as the coefficient 1 in the following regression: 10101/itititititit X PDRRRDR (Eq. 2) where the i and t subscripts denote the firm and period, respectively. X is the earnings per share, P is the price per share, R is the return from 9 mont hs before fiscal year-end t

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9 to three months after fiscal year-end t and DR is a dummy variable that is equal to 1 if 0 R and 0 otherwise. Basu describes conservative accounting as the asymmetric recognition of good news and bad news. The proxy for news is the sign of the stock return: good news firms are those with positive stock returns and bad news firms are those with negative stock returns. The coefficient 1 in Eq. 2, captures the incremental response of earnings to bad news over the response to good news. Because companies provide for all the losses and defer all gains, more timely rec ognition of bad news compared to good news as measured by the 1 coefficient implies more conser vative accounting (see Fig. 1). This operationalized measure of conservatism has been used in numerous studies to assess the degree of accounting conservatism present across companies and countries (e.g., Ball et al., 2000; Giner and Rees, 2001; Givoly and Hayn, 2000; Givoly et al., 2003; Holthausen and Watts, 2001; Pope and Walker, 1999). Figure 2-1. Graph of earnings regresse d on positive and negative returns. 01 : slope for R<0 R 0 : slope for R>0 X

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10 Accruals Conservatism Givoly and Hayn (2000) consid er the above-mentioned defi nitions of conservatism ambiguous. Their reason for ambiguity is the idea presented by B eaver (1998) in his definition of conservative behavior: what c onstitutes conservative earnings behavior in one period may imply non-conservative ea rnings behavior in some later period (p. 112). For example, both the balance sheet and th e income statement will be affected in a conservative manner when R&D expenditure is fu lly expensed in the period that they are incurred, i.e., the company will have underval ued net assets and lowered net income in the period of the expenditure bu t higher net income in the s ubsequent periods. Hence, Givoly and Hayn (2000) state an alternative definition of cons ervatism that captures the multi-period dimension as the selection cr iterion between accounting principles that leads to the minimization of cumulative repo rted earnings by slower revenue recognition, faster expense recognition, lower asset valuatio n, and higher liability valuation (p. 292). They suggest that the sign and the magnit ude of accumulated accruals over time are measures that can be used to gauge the degr ee of accounting conservatism. A consistent predominance of negative accruals across firm s over a long period is, ceteris paribus, an indication of conservatism, while the rate of accumulation of net negative accruals is an indication of the shift in the degr ee of conservatism over time (p.292). Givoly and Hayn (2000) calculate the accumu lated total accruals as the difference between cumulative net income (before depreciation and amortization) and the cumulative cash flows from operations at the end of each of the years 1966-1998 and find that for the period 1966 to the early 1980s, th e firms generated net positive accruals and from 1982 to 1998 there was a continuous accumulation of negative accruals, which they interpret as evidence that financial reporting has become more conservative. They break

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11 down the cumulative total accruals into cumulative operating and cumulative nonoperating accruals and find that it is the cumulative nonoperating accruals that have become increasingly negative, whereas cumulative operating accruals have become increasingly positive (see Fig. 2). They assert that this predominance of negative cumulative nonoperating accruals cannot be expl ained by restructuring charges, mergers and acquisitions, increased cost of pension and post-retirement be nefits, growth, and inflation based on additional analysis that c ontrols separately for each of these factors (their results for this additional anal ysis are not reporte d in their paper). Figure 2-2. Cumulative accruals by type, 19651998 (constant sample of 896 firms). Total Accruals (before depreciation): (Net Income + Depreciation) Cash Flow from Operations. Operating Accruals: Accoutns Receivable + Inventories Prepaid Expenses Accounts Payable Taxes Payable. Nonoperating Accruals: Total Accrua ls (before depreciation) minus Operating Accruals. Source: Givoly and Hayn (2000), Fig. 1, p. 303

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12 The Puzzling Evidence on Conservatism Numerous studies have been conducted ba sed on the above-mentioned measures of conservatism (e.g., Ball et al., 2000; Bas u, 1997; Givoly and Hayn, 2000; Holthausen and Watts, 2001). Some of the conclusions that em erge from these empirical studies are: (1) the U.S. financial reporting is conservative (Basu, 1997); (2) the U.S. financial reporting has become increasingly conservative (Givoly and Ha yn, 2000; Holthausen and Watts, 2001); (3) the financial reporting system in common law countries (t he U.K., Australia, Canada, the U.S.) is more conservative comp ared to the financial reporting system in code law countries (France, Germ any, Japan) (Ball et al., 2000). While Basu (1997) and Givoly and Hayn (2000) show that the U.S. is conservative and that financial reporting has become increasingly conservative using the income statement conservatism measure, Bowen, DuCh arme, and Shores (1995) directly examine firms choices of depreciation and invent ory methods during the 1980s and early 1990s, and find a near-monotonic and large shift towa rds straight-line de preciation and FIFO from accelerated depreciation and LIFO, which indicates conservatism has been decreasing over time in the U.S. Ball et al. (2000) explain thei r findings based on the differe nces that the law system creates. They theorize that in common law countries, where companies are mostly owned by the public, there is a demand for publ ic disclosure that induces conservative reporting by the companies in order to protect themselves against litigation. On the other hand, this lack of demand for public disclosu re in code law count ries does not require conservative reporting, because companies are mo stly owned by financial institutions or families and thus information asymmetries are resolved privately.

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13 An inherent tension in the argument of Ball et al. is that while on the one hand there is a demand for public di sclosure that induces conser vative behavior, on the other hand the same public demands accurate, unb iased financial repor ting. Gigler and Hemmer (2001) show that companies with more conservative accounting are less likely to make timely voluntary disclosures co mpared to those with less conservative accounting and thus, they conclude that price mo re timely reflects the news of firms with less conservative accounting. Moreover, even though the U.S. is more conservative as measured by Ball et al. (2000), Pope and Wa lker (1999) show that the differences between the U.K. and the U.S. reverse when th e analysis is done ba sed on earnings after extraordinary items, i.e., the U.K. becomes more timely in the recognition of bad news compared to the U.S. This raises two que stions: (1) whether financial reporting is comparable across countries even though they use similar law systems and (2) whether the income statement conservatism measure is sensitive to the defi nition of earnings. Pownall and Schipper (1999) provide an answ er to the first ques tion by addressing the differences that exist between U.S. GAAP and non-U.S. GAAP. They state that speaking to the type and ma gnitude of noncomparabilities as captured by Form 20-F reconciliations, research gene rally finds substantial negative differences between U.S. GAAP and home GAAP income, consistent with U.S. GAAP being on average more conservative than non-U.S. GAAP and consistent with a lack of aggregate comparability (p. 264). Another empirical example is provided by Gi ner and Rees (2001). They state that an examination of the accounting practices s uggests that pervasive conservatism would be greatest in Germanythe classic stakehol dercode law area, intermediate in France and least apparent in the U.K. It may be e xpected that the more developed equity market

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14 in the U.K., and the more frequent occurren ce of widely held firms, would discourage pervasive conservatism, as it might be exp ected to produce earnings numbers of less relevance to shareholders, and to reflect badly on the reputation and remuneration of managers (p. 1299). However, the empiri cal evidence using the income statement conservatism measure points in the exact opposite direction: the U.K. is the most timely in recognizing bad news (i.e., most conserva tive) compared to the code-law countries, France and Germany. Germany turns out to be th e least conservative of the three. Giner and Rees (2001) also show that in the U.K., firms with low (high) market-to-book ratios have higher (lower) income st atement conservatism. This would indicate that the two conservatism measures point in opposite directions. Lara and Mora (2004) reach similar conc lusions and find that the existence of balance sheet conservative practices is asso ciated with reduced levels of earnings conservatism. Givoly et al. (2003) explain why balance sheet conservatism may produce lower income statement conservatism as follows: The application of conservative accoun ting methods and practices such as expensing of software development costs, providing for anti cipated losses, the immediate write-off of goodwill upon acquisition and the use of accounting methods such as LIFO and accelerated depreciation, would minimize the book value of net assets. As a result, the app lication of lower-of-cost-or-market-rule will be less frequent and the greater responsiven ess of earnings to subsequent bad news will tend to be less pronounced. In contrast aggressive reporting in the form of extensive capitalization and inadequate prov isions for future costs or losses will make the firms earnings more sensitive to unfavorable economic events. (p. 6). They provide evidence that the income statement conservatism measure (which they label as the differential timeliness (DT) measure), is not rela ted to the rate of accumulation of negative accruals (also fo r nonoperating accruals) and is negatively correlated with other dimens ions of conservatism.

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15 Pae, Thornton, and Welker (2004) show th at income statement conservatism is substantially greater in portfolios of firm s with lower price-to-book ratios than in portfolios of firms with higher price-to-book ratios and further find that the negative association between income statement cons ervatism and the price-to-book ratio is primarily due to the accrual component of earni ngs. In the following section a model is presented to explain these empirical results. The Model The company is assumed to be an all-equity firm.1 The market value of the company is denoted by V and defined as the pr esent value of all the future dividends. The stock return, R, is: 1 1 ttt t tVVDIV R V (Eq. 3) The market-to-book ratio will be used to cap ture the degree of conservatism on the balance sheet and the growth factor. In orde r to model the effects separately, the marketto-book ratio will be split into two ratios: VVM B MB (Eq. 4) where M denotes the market value of net assets in place and B denotes the carrying value of net assets on the balance sheet. V is the market value of the firm: sum of the market value of current assets in place and the market value of net present value of future projects. Modeling the market-t o-book ratio this way enables the capture of the different sources of understatement men tioned in Givoly et al. (2003). / VMcan be interpreted as capturing the growth factor as valued by th e market since the features of financial 1 An all-equity firm is assumed for mathematical ease. The analysis can be extended to debt-financed firms without loss of generalizability.

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16 reporting (e.g., historical cost convention) do not allow for the valu ation of net present value of future projects. / M Bcan be interpreted as capturi ng the degree of conservatism on the balance sheet that is purely due to accounting choices. For example, if VM this means that the net present value of future projects is 0 and that this is a no-growth firm. When this is the case, // VBMB i.e., market-to-book ratio measures the degree of conservatism on the balance sheet without the interaction of the growth factor. Therefore, accounting choice and regulation are the only fo rces behind conservative practices via minimization of the carrying va lue of net assets in place. However, whenVM then the market-to-book ratio become s a noisy proxy for conservatism on the balance sheet because of the inter action between growth and conservatism. No Growth Case //// VBVMMBMB Assume that the company has no positive present value projects so that /1 VM In this case, / VB is purely an indicator of conser vatism on the balance sheet. The degree of balance sheet conservatism will be denoted by is the book-to-market ratio, the inverse of the market-to-book ratio: 11 tt B V (Eq. 5) Thus, 01 captures the degree of balance sheet conservatism that exists at the beginning of the period, i.e., increased implies less conservatism on the balance sheet. For example, in the extreme case where 0 the company has expensed all of its assets; 1 implies fair-value accounting, i.e., book value equals market value; and 1 implies overvaluation of assets with respect to the market value. The accounting earnings per share, X, will be assumed to be calculated using the historical cost, revenue rec ognition and matching principl es. Assume that there no

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17 dividends paid out2 and that the market incorporates all kinds of information into the market price (i.e., efficient markets hypothesis) then the reported earnings per share, E, will be the minimum of accounting earnings or the difference between the market value and the beginning book value (because of the ap plication of lower-of-cost-or-market rule (LCM)): 1min[,]ttttEXVB (Eq. 6) The LCM dictates departure from the hist orical cost principle when the market value of the assets in place is no longer as great as their or iginal cost. Thus, the company can report its accounting earnings when the di fference between the market value and the beginning book value is at least equal to the current accounting earnings amount, but reported earnings have to be adjusted when this difference is less than the current accounting earnings, which implies that there has been a downward market valuation of the companys assets in place. Substituting Eq. 5 into Eq. 6 results in: 1min[,]ttttEXVV (Eq. 7) Adding and subtracting 1 tV to the second term in Eq. 7 yields the following: 11min[,(1)]tttttEXVVV (Eq. 8) Thus, reported earnings can either report the accounting earnings for the current period or a garbled number base d on the markets valuation. 1(1)tV can be interpreted as the reserve that has been created via conservative behavior on the balance sheet. For example, if th e companys degree of conservatism, is 0.90, then 2 This is assumed for ease of discussion. It does not change the interpretation of the following analysis.

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18 the book value is 90 when the market values it at 100. Thus, the company has created a reserve of 10. Assuming that 01 i.e., the companys balan ce sheet is not overvalued compared to the market, the reported ear nings amount depends on two things: the comparison between the cost of equity capital, r, and the stock returns, t R ; and the degree of balance sheet conservatism: 1. If trR then EX always. This means that if the market perceives a positive change in value over the period (i.e., good market news), the reported earnings will always equal realized earnings. In this case, the degree of balance sheet conservatism, does not matter. 2. If trR i.e., bad market news, then the reported earnings depends on the magnitude of the decrease in market value of assets and the degree of balance sheet conservatism: a. If 11(1)tttt X VVV then EX as in case (a). The accounting earnings are less than the change in ma rket value and the reserve created via balance sheet conservatism. Notice that increased reserves on the balance sheet will help this relationship to hold. Thus, the magnitude of the bad market news can be hidden behind the balance sheet conservatism and the company does not have to incorporate the bad market news into its accounting earnings. b. If 11(1)tttt X VVV then 11(1)tttEVVV The accounting earnings are greater than th e change in market value and the reserve. The company has to incor porate the decrease in value of its assets as perceived by the market a nd into its current reported earnings. Notice that higher reserves created via balance sheet conservatism will enable the company to report hi gher accounting earnings than the economic income. The income statement conservatism as captured by the regression in Eq. 2 implies that returns and earnings are mo re highly correlated when the stock returns are negative. If stock returns are negative, then: 1 1 100ttt tt tVVDIV RVV V

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19 Given that conservatism is applied as de scribed above to the reported earnings, then the correlation between st ock returns and reported earnings is as follows: 1 11 1(,) (,min[,(1)])tt tttt tcorrelationRE VV correlationXVVV V (Eq. 9) If trR then 1 1(,)tt Gt tVV X V If trR then 11 11 11(,) or (,(1))tttt Btttt ttVVVV X VVV VV Thus, BG the correlation between returns and reported earnings will be much higher in case 2especially when the compa ny cannot rely on excess reserves created by conservative practices on th e balance sheet and when the 10ttVV constraint is imposed (assuming that cost of equity capital is a positive number). Hence, the companies that are deemed to be more timely in capturing bad news cannot necessarily be described as reporting in a conservative ma nner. The above analysis shows that these companies are in fact less conservative on their balance sheet and their timeliness in capturing bad news is because they cannot hid e their bad market news and they are forced to reveal it in line with the mark et. Moreover, the higher the balance sheet conservatism, the easier it is to report the accounting earnings without worrying about the LCM rule, because assets in place have alr eady been written down much lower than the markets valuation. Hence, the correlati on between returns and reported earnings would be lower, which explains, for example, why Germany, a country considered to be very conservative on its companies balance sheets shows up as the leas t timely country in reporting bad news. This analysis explains the recently documented empirical results on the relationship between income statement a nd balance sheet conservatism. However, it

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20 should be noted that the relati onship is not a linear one, but rather one that depends on the degree of balance sheet conservatism and th e magnitude of the change in value as perceived by the market. Growth Case //// VBVMMBVM Now assume that the company reports its carrying net assets in an unbiased manner on the balance sheet so that /1 MB i.e., the balance sheet is reported at fair value3. In this case, / VB is purely an indicator of the expected growth of the assets in place. Assume that earnings still follow the conservatism principle as implied in the saying, anticipate no profits and provide for al l the losses. Now assume that there is a surprise element in the reported ear nings that the market reacts to: []u x Exx (Eq. 10) where x is the rate of return on equity (ROE), i.e., 1/ttEB ; [] Ex is the expected ROE, i.e., 1[]/ttEEB; and u x denotes the unexpected portion of the ROE, i.e., 1/tUEB (where UE denotes the unexpected po rtion of reported earnings). Given the surprise element in the earnings, the stock returns, R will be: []u R ERR (Eq. 11) where [] E R is the expected rate of return and u R denotes the unexpected stock returns, i.e., 1/tURV (where UR denotes the unexpected change in valuation). If the surprise in earnings were re ported in an unbiased manner, then the numerators of the unexpected ROE and the une xpected stock returns would be equal to each other, i.e., UEUR However, since the earni ngs are known to follow the 3 This assumption is not necessary for the analysis. It is assumed in orde r to isolate the effect of growth from biased reporting on the balance sheet.

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21 conservatism principle, the market valuati on of the unexpected portion of the earnings will be in the following way: 1. 0 UE : There is unexpected bad company news reported in earnings. Because the market knows that the company has to exercise the conservatism principle on the income statement by accounting for the worst case scenario, the stock return adjustment will exactly equal the une xpected bad company news, i.e., URUE 2. 0UE: There is unexpected good company news reported in earnings. Again, the market knows that the financial re porting system does not allow for the complete recognition of good company news before the related earnings are completely realized. Now, assume that th e positive earnings surprise is permanent4 and is expected to grow at a rate of g determined by the market (that is less than [] ER ). Then the unexpected change in valu ation of stock will be calculated in the following way: [] UE URUE ERg (Eq. 12) Income statement conservatism is driven by asymmetric recognition of gains and losses. As growth does not imply unexpected good company news or unexpected bad company news, a given level of growth in present value projects should not affect the income statement conservatism. However, the stock market reaction to the unexpected news as reported by the company depends on the growth factor. The income statement conservatism as measured by Basu (1997) (see Eq. 2) measures the differential effect of negative returns and positive re turns on earnings. If the company is a growing company, then the difference between positive returns and negative returns will be greater with increased growth (growth is assumed to be less than expected stock returns) since the denomina tor in Eq. 11 will get smaller with higher growth resulting in greater positive stock returns when there are positive earnings 4 Even though this is not a realistic assumption, it does not change the interpretation derived from the analysis. Assuming that there are transitory and pe rmanent components to the positive earnings surprise would decrease the numerator in Eq. 12, but the unexpe cted change in market price would still be higher than the earnings surprise.

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22 surprises. Hence, a market-to-book ratio greater than 1, which indicates positive growth in this case, will result in higher income statement conservatism (where there is no balance sheet conservatism). By splitting the market-to-book ratio into two portions, one m easuring the growth factor, / VM, and the other measuring the conservatism factor, / M B, the interaction of growth with conservatism and how it affects income statement conservatism is observed. Income statement conservatism is increasing in /VM and decreasing in / M B. Therefore, given the growth and no-grow th scenarios, two conflicting results emerge with respect to the relation between income statement conservatism as measured by Basu (1997) and balance sheet conservatism as measured by the market-to-book ratio: (1) when there is no-growth, higher income statement conservatism is associated with lower market-to-book ratio and (2) when there is growth and no balance sheet conservatism, higher income statement conser vatism is associated with higher market-tobook ratio. Thus, the link between income statement conservatism and balance sheet conservatism cannot be adequately interprete d without accounting for the growth factor.

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23 CHAPTER 3 THE EFFECTS OF RULESVS. PRINCIPLES-BASED STANDARDS AND FAMILIARITY Among the most cited causes of the curre nt accounting crisis are overly complex accounting standards, emphasis of form over substance in applying accounting standards, and the failed independence of auditors (P iecara, 2002). The Sarbanes-Oxley Act of 2002 includes provisions aimed at the removal of these fundamental problems. There are two important provisions in the Act that closel y relate to the topic of this chapter. Section 108 of the Act instruct s the SEC to study the feasibil ity of adopting a principlesbased accounting system. Section 203 of the Act requires the rotati on of audit partners every five years and Section 206 prohibits the audit of a company if the companys CEO, CFO, controller, CAO or person in equivale nt position has been employed by the audit firm during the one-year pe riod preceding the audit. An overlooked point by the e xperimental studies conducted in prior literature to discern the varying effects of rulesvs. pr inciples-based standards on decision-making is that the auditing process is embedded in an interactive relationship between the auditor and the client. Antle and Nalebuff (1991) pointed out that the financial statement becomes a joint venture if the auditor is unwilling to provide an unqualified opinion on managements stated representations. In ot her words, whenever there is a disagreement on the reporting decision of acc ounting issues, the auditor and the client will have to collectively resolve the conflict in order to i ssue an unqualified opinion.

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24 I designed an experiment where the impact of rulesvs. principles-based standards can be explored within the context of the existing relationship be tween the auditor and the client. Magee and Tseng (1990) showed that there exists a link between auditor independence and the type of sta ndard. Thus, a factor that na turally has to be considered and included in such an experimental set ting is the degree of familiarity between the auditor and the client. This is especially so when auditor inde pendence has been the concern of many regulatory agencies and th e accounting profession (Glazer and Jaenicke, 2002). The experiment was conducted using se nior and graduate students studying accounting. In the experiment, the students we re assigned to pairs, where one was asked to role-play as the auditor and the other was asked to role-play as the client. The auditors were instructed to question the reporting of a certain accounting transaction by their clients, which increased the net income of the company and were asked to suggest an alternative way of reporting to their clients. Both the auditors and the clients were provided with current GAAP that supported their point of view. Threat of lawsuits and threat of client loss coul d possibly influence the outcome of the mini discussion by giving the client an upper-hand (Farmer, R ittenberg, Trompeter, 1987). To remove the possible effects of these factors, the subjects were informed that there was no threat of litigation and the client coul d not fire the auditor. The collective reporting decision of the a uditor and the client depended upon (1) whether they employed rules-based or prin ciples-based standards to discuss the accounting issue, and (2) whether they pers onally knew each other or were meeting for the first time. The pairs were asked to discu ss the issue and make a joint decision. Pairwise conclusion was the binary dependent va riable and could either be INCOME as

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25 favored by the client or INVE NTORY as favored by the auditor. The type of accounting standard employed in determining the a ppropriate reporting method was manipulated between subjects, as was the familiarity factor The results indicated that the likelihood a client agrees with an auditors position incr eases when the auditor and the client resolve the issue using rulesrather than principles-b ased standards. Familiarity by itself did not have an impact on pair-wise conclusions. Howe ver, familiarity and the type of standards jointly affected the outcome of conflict resolution between the auditor and the client. When the client and the auditor were not familiar with each other, the pair-wise conclusion was not dependent on the type of accounting standards employed. However, when the client and the auditor were familia r with each other, the likelihood that the conclusion was in clients favor increased when principles-based standards were employed, and the likelihood that the conclusion reflected the auditors opinion increased when rules-based standards were employed. Theoretical Basis for Experiment Design Gibbins, Salterio, and Webb (2001) develop a model of auditor-client accounting negotiation and design a field questionnaire that was completed by audit partners about real negotiations with clients. Negotiation is defined as any context in which two or more parties with differing views jointly make a decisi on that affect the welfare of both parties. The negotiation process is described as a thr ee-element process model, which begins with an accounting issue (based on pa st negotiations or relations hips between the parties), followed by different choices and actions that constitute the auditor-client process, and results in a negotiation outcome. In this process, each negotiation has the potential to become an antecedent for the next negotiation, making it a continuous round of discussions until a final resolution is reach ed. The three-process model is closely

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26 associated with accounting contextual featur es that provide practical meaning to the model. These features are external conditions and constraints, inte rpersonal context, and parties capabilities (G ibbins et al., 2001). The experiment was designed to replicate one round of this th ree-element process model. The subjects were provided with an accounting issue along with a brief history of the auditor-client relationship; the auditor a nd the client were asked to discuss the issue between them; and an outcome was required to be reported at the end of their discussion. The conflict was created by inst ructing the auditor and the c lient to adopt opposing points of view. Gibbins, McCracken, and Salterio (2003) e xplore the client side of the same negotiation process described in Gibbins et al. (2001). In bot h studies, the audit partners and the CFOs report accounting and disclosure standards as one of the most important external factors during auditorclient negotiations. In both studies, the relationship with the other side constituted one of the most important interpersonal factors. This outcome can be somewhat biased since the le ngth of the relationship between the auditor and the client in both studies was reported to be more than three years for most of the sample, indicating that most were already fa miliar with the person they were negotiating with. The experiment was designed to isolat e the effects of these two important factors from the other contextual factors and to reveal the impact they may have on the accounting outcome when the negotiation was limited to only one round of discussion. A puzzling issue that arises from the join t analysis of both pa pers is the reported outcome of the negotiated issue. 32% (19%) of the audit partners (CFOs) reported that the negotiation outcome was agreement on aud itors original position whereas only 4% (34%) of the audit partners (CFOs) reported that the negot iation outcome was agreement

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27 on clients original position. The percen tages reported in bot h studies tell opposing stories as to whose original positions wins at the end of a negotiated issue. Since both these studies are field questionnaires collecti ng subjective informati on, it is not possible to objectively verify the reported percentages. The designed experime nt has the potential to provide insight into this puzzle. Background and Hypotheses Rulesvs. Principles-Based Standards A closer look at the development of st andards and the definition of rulesvs. principles-based standards is necessary in order to understand how we came upon the debate and distinction between rulesvs. principles-based standards. The need to develop a comprehensive set of accounting standards first arose after the market crash in 1929. Since then, there have been other major market crashes, the most recent being the so-called burst of the Tech Bubble. The aftermath of almost every market crash has eventually led to the questioning of accounting standards in effect at the time, their structure, and whether th ey had been comprehensive enough to predict or to prevent the imminent crash (refer to appendix for a summary of historical account of the development of standards). After nearly a century of developing accounting standards, the debate on rulesvs. principles-based standards is fueled once agai n. It is important to understand what is meant by these terms. A likewise distinction is made in the law literature between rules vs. principles. Brasil, Jr. (2001, pp. 67-68) summarizes the law literature on rules and principles as follows: Dworkin (1978) claims that rules have abso lute obligations equivalent to all-ornothing whereas principles do not have this kind of absolute obligation.

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28 According to Dworkin, principles are sele cted based on the importance of the value they attain to whereas rules are not value-laden. Alexy (1978) claims that one way of disti nguishing rules from principles is the abstraction degree on their pr escriptions, which is not just a matter of degree but also a matter of quality. Peczenik (1989) assumes that principles are normative propositions and not descriptive statements. Verheij (1996) proposes that the difference between rules and principles is merely gradual and that there is no differen ce in logic structure between the two. Recent accounting literature has made the di stinction along parallel lines. Vincent et al. (2003) characterize the standard setting-proce ss and its products along a continuum ranging from unequivocally rigid standards on one end to general definitions of economic-based concepts on the other end (p. 74). The rigid end of the spectrum leaves no room for judgment or disagreemen t whereas the general end of the spectrum requires the application of professional judgment and expertise both by managers and accountants. Nelson (2003) defines rulesvs. princi ples-based standards in a similar way by adopting the incremental perspective. He vi ews all standards as principles-based since the FASB is assumed to be issuing standard s based on the conceptual framework. Thus, he characterizes the issue as the incrementa l effect on behavior when standards include relatively more elaborate rules. He focuses on the incremental effects of increasing the number of rules in a standard where he defines rules to inc lude specific criteria, bright line thresholds, examples, scope restric tions, exceptions, subsequent precedents, implementation guidance, etc. (p. 91). The FASB has issued a Proposal for a Principles-Based Approach to U.S. Standard Setting (FASB 2002) in response to concer ns about the quality and

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29 transparency of financial reporting. There are mixed reactions to the proposal. Some academics find the proposal in conflict with the existing constraints posed by the legal, technological, and business environment (S chipper, 2003), while others embrace the notion on the grounds that managers use rulesbased standards to st ructure transactions (Nelson, 2003; Vin cent et al., 2003). Initially, the accounting profession has been concerned a bout the lack of accountants power over their cl ients (Sterling, 1973). Th e issuance and application requirement of more strict a nd clear rules have been viewed as an empowering tool for the auditor against clients who are inclined to interpret stan dards in a way that justifies their aggressive reporting deci sions. This perspective has re sulted in a highly technical, complex, and detailed set of accounting sta ndards. Magee and Tseng (1990) found that auditor independence is easier to maintain when standards leave little room for disagreement among auditors. However, more recent research clearly pointed out that replacement of vague standards with precise standards does not mitigate aggressive reporting in tax contexts (Cuccia, Hackenbr ack, and Nelson, 1995). Based on the results of Cuccia et al., one can make the analogy that using rulesvs. principles-based standards should not necessarily have an effect on the re porting decision of auditors. Hackenbrack and Nelson (1996) further explore the issue in the audit arena wh ile introducing an additional factor that might mitigate the aggr essiveness of auditors reporting decisions, namely the engagement risk. Results of their study indicate that the nature of standards does not influence the outcome of the repor ting decision: They showed that under moderate engagement risk, auditors permitted aggressive reporting method by their clients under both rulesvs. principles-based standards, whereas under high engagement risk, the auditors reverted to more conservative interpretation of standards.

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30 Recently the perspective that rules-ba sed standards empower auditors has suddenly swung in favor of the clients: ru les-based standards now are perceived to empower clients by enabling them to structur e transactions to mana ge their earnings. This is currently quoted as one of the main reasons why re gulators want to revert to principles-based standards. Nelson, Elliott, and Tarpley (2002) analyzed data collected from 253 auditors on 515 specific earnings management incidences by using a fieldbased questionnaire. Their results indicated that managers are more likely to attempt earnings management by structuring transact ions using high precise standards [i.e., rules-based] rather than low precise standa rds and that auditors are less inclined to interfere with such attempts. On the othe r hand, the percentage of earning management attempts adjusted by the auditor was still hi gher for the high precision standards (51%) compared to the low precision standards (3 9%). In addition, the number of earning management attempts was higher for the low precision standards (313) compared to the high precision standards (202). In this experiment, the type of standa rds is manipulated between subjects to examine the impact of rulesvs. principles-based standards on the outcome of conflict resolution. Since the recent literature indica ted that different types of standards do not mitigate aggressive reporting of auditors and since this fact would only be exacerbated by closer relationships between th e auditor and the client, the h ypothesis stated in alternative form is as follows: H1: The likelihood that a clie nt agrees with an audito rs position increases when the auditor and the client reso lve the issue using rulesrather than principles-based standards.

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31 Familiarity The accounting literature on familiarity is fa irly limited in scope and explores the issue only from the accountants side. Most studies conducted on the topic are limited to the effects of familiarity in the audit sett ing concerning the relationships between the senior auditors and their staff (Asare a nd McDaniel, 1996; Ramsay, 1994; Wilks, 2002). There are no behavioral studies that exp licitly examine how familiarity between the auditor and the client may affect the outco me of an actual discussion between the two with regard to the reporti ng decision of a conflicting accounting issue. An emerging theme from the existing studies is that fam iliarity with the group members of an audit team can potentially become a source of j udgment bias in the teams performance (Tan and Jamal, 2001; Asare and McDaniel, 1996). Likewise, long running interactions between the client and the a uditor can also be a potent ial source of judgment bias (Dopuch, King, and Schwartz, 2001) and a thr eat to auditor inde pendence (Glazer and Jaenicke, 2002), which explains why the Sarb anes Oxley Act includes specific provisions for auditor independence. Th e implicit assumption underlying the mandatory rotation of auditors is that potential economic gains fr om continuing interactions with the same client undermine auditor indepe ndence (Dopuch et al., 2001). This experiment manipulates the degree of familiarity between-subjects to examine its effect on the outcome of a conflic t resolution. The second hypothesis is: H2: The more familiar an auditor is with a client, the more likely s/he is to agree with a clients position.

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32 Method Experimental Design An experiment was conducted to test the e ffects of different types of standards and familiarity on the resolution of a conflict betw een the auditor and the client. The subjects were paired up where one subject was asked to role-play as the auditor and the other was asked to role-play as the client. The pa irs were provided with a case in which the appropriate conclusion to the accounting issue in question could be resolved by using the accounting standards they were provided with. The experiment employed a 2 x 2 between-s ubjects design (Table 3-1). There were two different units of observation: One was observation based on individual reports and the other was observation of a pa ir of students. The dependen t variable measured is the binary outcome of the conflict resolution (0=INCOME for client-favoring outcomes, 1=INVENTORY for auditor-fa voring outcomes). One variable was the type of standards. The standards manipulation involved the resolu tion of a conflicting accounting issue by employing either rulesor pr inciples-based standard s. Pairs assigned to the rules-based standard condition were pr ovided with a case in which the ambiguous accounting issue could be resolved by employing rules-based standards. Both the auditor and the client were provided with rules-ba sed GAAP that appropriately supported their stance on the matter. Auditors were given an excerpt from SAB 101, Revenue Recognition in Financial Statements (SEC, 1999), and clients were given an excerpt from SFAS 45, Accounting for Franchise Fee Revenue (FASB, 1981). Pairs in the principlesbased standard condition were provided with GAAP that was not rules-based. Auditors were provided with standards from ARB 43, Restatement and Revision of Accounting Research Bulletins (CAP, 1953), on inventory and client s were provided with standards

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33 from SFAC 6, Elements of Financial Statements (FASB, 1985), on characteristics of gains. Table 3-1. 2x2 between subjects design and th e number of pair-wise observations in each cell Familiarity UnfamiliarFamiliar Total Principles17 16 33 Standards Rules 16 16 32 Total 33 32 65 The other manipulated variable was familiarity. This manipulation was achieved by informing half the pairs to assume that they had known each other for at least five years personally and professionally1 and the other half was aske d to assume that this was their first encounter with each other.2 Table 3-2 summarizes the experimental de sign, indicating how the standard and the familiarity manipulations interact to de termine the outcome of the resolution when different types of standards are us ed (related to H1) at two levels of familiarity (related to H2) during conflict resolution. When the pa rticipating pairs are in the rules-based standards condition, familiarity between the subjects does not increas e the likelihood that the auditor will agree with the clients position. When the participating pairs are in the principles-based standards condition, familia rity between the subj ects increases the likelihood that the auditor will ag ree with the c lients position. 1 Familiar auditor instructions: Your meeting at the headquarters is scheduled with the CFO, whom you have personally known for over five years. You have worked with him/her on four other engagements and have found him/her to be both conscientious and cooperative. You have attended several social gatherings together and have enjoyed each others company. You both know that the two of you get along well. 2 Unfamiliar auditor instructions: Your meeting at the headquarters is scheduled with the CFO, who has been with the company for some time and is known to be both conscientious and cooperative. You do not personally know anything about him/her. This will be the first time that you will be meeting him/her in person.

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34 Subjects The participants were students who were enrolled in Intermediate Financial Accounting class and Professional Accounti ng Research class at Fisher School of Accounting, University of Fl orida. The experiment was conducted at the beginning of their classes. All those who were present at the beginning of the class participated in the experiment. The total number of particip ants was 130 students (65 pairs of students), with 50 students from two sections of th e Professional Research class and 80 students from three sections of the Financial Accounti ng class. The participants were all above the age of 21 and were all classified as at l east a junior in the progr am. The students from the Professional Research class did not receiv e any compensation for participating in the experiment. As for the students from the Fina ncial Accounting class, the participation in the experiment counted as an extra lab grade, which constituted less than 1% of the total course grade. An additional variable was included in the statistical analysis to test if the two levels of compensation had an effect on the reporting decision of the pairs. Table 3-2. Experimental design and predictions. Familiarity Accounting Standard Unfamiliar Familiar Rules-based Auditors position Inventory Ad justment Inventory Adjustment Clients position Income Income Principles-based Auditors position Inventory Ad justment Inventory Adjustment Clients position Income Income Procedure The students were asked to get into groups of two and were told that they would be role-playing as either the auditor or the chie f financial officer (CFO) of a company. Each pair was distributed different sets of inst ructions. The experiment comprised of two

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35 parts. In the first part of the experiment, the auditors received a set of instructions informing them about their role along with a description of the accounting issue that needed to be resolved. Half the auditors we re told that they were familiar with their clientthat they were friends with the CF O and also knew them professionally. The other half was told that this would be the first time they w ould be interacting with their client. Likewise, the CFOs received a set of instructions informing them about their role along with a description of the problem. The familiarity manipulation was applied to the clients same way as it was applied to the auditors. The case was adapted from the Deloitt e & Touche Trueblood Accounting & Auditing Case Study Series. The accounting is sue in question was th e classification of $1,000,000. This amount could either be report ed as an adjustment to inventory in the following period or as income for the curre nt period. After reading the case, the participants were asked to write down and hand in to the experimenter their personal opinion as to how the issue should be resolved. In the second part of the experiment, the standards manipulation was applied in addition to the familiarity manipulation. Th e participants were provided with a second set of instructions. Half th e pairs received principles-based standards that supported their arguments and the other half received rules-base d standards. The auditors were told that their subordinates report indi cated the appropriate treatmen t to be an adjustment to inventory in the following period supporte d by the provided accoun ting standard. The clients were told that for the companys tax purposes and in order to receive the bonus for the current period, the amount in question should be reported as income. They were also provided with appropriate accounting standa rds that supported their argument, albeit different from the ones the auditors received. All standards provided to both auditors and

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36 clients are part of current GAAP and no st andards were made up to support their arguments. Each pair, consisting of an auditor and a client, was then asked to discuss the issue between them based on the standards provided. Half the pairs discussed the issue solely based on rules-based standards and the other ha lf discussed the issu e based on principlesbased standards. All pairs were told that th e financial statements had to be published the next day and they had to make a joint c onclusion on the matter based on the information they had. The threat of litigation and the removal of the auditor from the current assignment are two factors in prio r literature that have been suggested to in crease the likelihood that the auditors will agree with their clients (Farmer et al., 1987). To remove the confounding effects of these factors, the part icipants were informed that there was no threat of litigation posed by either of the accounting treatments in question and that the client could not fire the auditor. At the end of their discussion, the particip ants were asked to i ndividually report the concluding reporting deci sion; whether the amount in ques tion should be recorded as an inventory adjustment or income. This response provided data to test H1. The participants were also asked to rate how fa miliar they felt with each other on a ten-point scale (1=total stranger to 10=extremely familiar). This response was used to check for the manipulation of familiarity a nd was also used to test H2. Materials The case The case is about a company that has ente red an exclusive suppl y agreement with a supplier concerned about enhanced price competition from its rivals. Initially, the

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37 supplier offers to pay the company a nonrefundable amount of $1,000,000 in cash and promises best prices over the next two years in exchange for the signing of the exclusive supply agreement. In exchange, the company has no obligations to fulfill after signing the contract. Even if they renege and deci de to purchase from another supplier, they would still be entitled to claim the $1,000,000. The company declines to receive the $1,000,000 in cash and instead asks the supplier to issue a credit memo of $1,000,000 that could be applied towards future purchases The underlying motive for this is to keep their tax bill low for the period while increasi ng their net income (by recording a gain of $1,000,000), which would entitle the managers to a generous bonus. The fiscal year ends the day after they sign the cont ract. The accounting issue is whether to record the amount in question as income for the period or whether to apply it whenever inventory is actually purchased from the supplier. Familiarity manipulation The subjects were provided w ith a description of the role that they were asked to play. Familiarity manipulation was based on the length of the relationship between the auditor and the client. Those assigned to the familiar group were told that they had known each other for five years personally and pr ofessionally. They were told that they had worked together on other business engageme nts, attended social gatherings together, had occasional barbeques with each others families on Sundays. Those in the unfamiliar group were told that this would be the first time that they would be meeting. Both groups were told that they were with someone who was known to be both conscientious and cooperative at work.

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38 Standards manipulation Rules-based standards. The auditors were provided with the following excerpt from SAB 101, Revenue Recognition in Financial Statements (SEC, 1999), to convince their client that the amount in question could not be record ed as income for the period since the credit memo was inseparable from th e purchase of inventory. Unless the client purchased inventory, the credit memo was d eemed worthless. There was no transaction that actually took plac e with the signing of the contract It was simply an executory contract. The only way to di sclose it would be in the footnotes to the financial statements. The staff states that revenue is realiz ed or realizable and earned when all of the following criteria are met: Persuasive evidence of an arrangement exists [ yes; an executive contract is in effect ], Delivery has occurred or services have been rendered [ no; inventory has not yet been purchased ], The sellers price to the buye r is fixed or determinable [ yes; $1,000,000 is fixed ], Collectibility is reasonably assured [ yes ]. Revenue may not be recognized before it is realized or realizable and earned. An amount received is not deemed to be earned under GAAP solely because it is nonrefundable In some circumstances, the right, product, or service conveyed in conjunction with the nonrefundable fee has no utility to the purc haser separate and independent of the registrants perfor mance of the other elements of the arrangement. Therefore, in the absence of the registrants continuing involvement under the arrangement, the customer would not have paid the fee The clients were provided with th e following excerpt from SFAS 45, Accounting for Franchise Fee Revenue (FASB, 1981), to justify the r eason why they could report the amount in question as income for the period. They argued that an analogy could be made

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39 to franchise fee revenues since no articulate st andards about the partic ular transaction in question existed in current GAAP. Franchise fee revenue from an individual franchise sale ordinarily shall be recognized, with an appropria te provision for estimate d uncollectible amounts, when all material services or conditions re lating to the sale have been substantially performed or satisfied by the franchisor. Substantial performance for the franchisor means that: (a) the franchisor has no remaining oblig ation or intent--by agreement, trade practice, or law to refund any cash rece ived or forgive any unpaid notes or receivables; (b) substantially all of the initial services of the franchisor required by the franchise agreement have been performed; and (c) no other material conditions or obligations related to the determination of substantial performance exist Principles-based standards. The auditors in this manipulation group were told that the amount in question could only be a pplied to future purchases, which made it inseparable from inventory and that the cr edit memo should be considered like a price discount, which is not the same as income. When a price discount it received, the inventory cost is adjusted to reflect the di scounted cost. By analogy, the credit memo should also offset inventory cost when the inventory is bought. Similarly, the credit memo could also be viewed like a big coupon: unless they ordere d inventory, it was worthless. They were provided with the following excerpt from ARB 43, Restatement and Revision of Accounting Research Bulletins (CAP, 1953), to help them argue their position. The term inventory is used herein to de signate the aggregate of those items of tangible personal property which (1) are held for sale in the ordinary course of business, (2) are in process of production fo r such sale, or (3) are to be currently consumed in the production of goods or services to be available for sale. A major objective of accounti ng for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

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40 The primary basis of accounting for inventories is cost which has been defined generally as the price paid or cons ideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. The clients in the principles-based standa rd manipulation group were told that the receipt of the credit memo represents inco me in exchange for signing the exclusive supply agreement. They were told that the credit memo, in substan ce, represents a gain to the company because it increa ses net assets and arises from a peripheral transaction. They were provided with the fo llowing excerpt from SFAC 6, Elements of Financial Statements (FASB, 1985), to support their argument. Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transac tions and other events and circumstances affecting the entity except those that result from revenues or investments by owners. Results Descriptive Statistics There were a total of 65 pa ir-wise observations. The number of observations in each cell is reported in Table 3-1. The Joint Decision In the first part of the experiment, the s ubjects were asked to report their personal opinion as to how the issue should be resolv ed. They could report their decision as adjustment to inventory, income, or undecided. Initially, 90% of the participants replied that the issue should be resolv ed as an adjustment to inve ntory, whereas only 7% of the participants thought it should be recorded as income. Th ere was little difference in personal opinions when compared across the two subsets of participants (Table 3-3, Panel A).

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41 In the second part of the experiment, af ter the subjects were asked to discuss the issue with each other, they were once again asked to repor t their personal opinion as well as the pair-wise resolution to the issue. This time 73% of particip ants reported that the amount in question should be recorded as inventory adjustment whereas those who thought it should be recorded as income rose to 22% (Table 3-3, Panel B). The difference between the sub samples appear ed to be greatest in this panel. When the pair-wise conclusions were obs erved, 72% of the conclusions were adjustments to inventory, whereas 28% were income (Table 3-3, Panel C). Table 3-4 provides a graphical illustration of how the personal opinions of auditors and the clients differed after the discussion. Overall, the percentage of auditors who believe the issue should be recorded as inco me increased to 15% whereas the percentage of clients who believe the issue should be recorded as income increased to 29%. 28% of the pair-wise conclusions were income. It a ppears that the auditors chose to agree with their clients despite their personal preferen ces. It seems that the outcome of the resolution reflects the clients point of view rather than the auditors. The auditors (clients) in ACG 4133 were more (less) pr one to lean towards the clients (auditors) side when compared to ACG 5816 observati ons (Table 3-4, Panels A and B). Likewise, there were more pair-wise co nclusions in favor of the client within the ACG 4133 participants (Table 3-4, Panel C). Manipulated Variables The pair-wise conclusions were reported as inventory by 47 of the pairs and income by 18 of the pairs out of a tota l of 65 pairs (Table 3-5). Mo re than half the pairs that concluded the outcome to be an adjustment to inventory were in th e rules-based standards manipulation whereas more than half the pair s that concluded the outcome to be income

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42 were in the principles-based standards (Table 3-5, Figure 3-1). More specifically, 33% of the conclusions in the principl es-based group were reported as income compared to 22% of the conclusions in the rules-based group, which suggests that discussing an ambiguous issue based on principles-based standards in creases the likelihood th at the auditor will agree with their client. Familiarity did not seem to have an e ffect on how the issue was resolved when compared based on only pair-wis e conclusions (Table 3-6). The total number of reported resolutions as income and as inventory was equally divided between the familiar and unfamiliar groups (Table 3-6, Figure 3-2). Howe ver, when the total sample was split into groups of INCOME and INVE NTORY based on pair-wise co nclusions, the type of standard and familiarity appeared to interact (Tables 3-7 and 3-8, Figures 3-3 and 3-4). Among the pairs with inventory conclusion, i. e., when the auditors position was agreed upon by the pair, more than half the pairs in the familiarity manipulation were in the rules-based group (Table 3-7, Figure 3-3). On the other hand, among the pairs with income conclusion, i.e., when the clients position was agreed upon by the pair, more than half the pairs in the familiarity mani pulation were in the principles-based group (Table 3-8, Figure 3-4). The type of standard did not have an effect on the pair-wise conclusions when the pairs were in the unf amiliar group. Only when the pairs were assigned to the familiar group did the type of st andard seem to have a differential effect on the pair-wise conclusions. Manipulation Check for Familiarity The participants were asked to report how familiar they felt with their partner after they had discussed the issue as a manipulation check for familiarity variable. The total sample was split into sub samples based on the familiarity manipulation. A t-test

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43 assuming unequal variances was conducted to see whether the mean difference in the degree of familiarity reported by individuals (1=total stranger to 10=extremely familiar) assigned to familiar and unfamiliar groups would be statistically different than zero. Tables 3-9 and 3-10 indicate that the mean difference between the unfamiliar and the familiar groups was significantly different than zero. The mean degree of familiarity reported by those in the unfamiliar group based on a ten-point scale (1=total stranger to 10=extremely familiar) was 6.53 compared to 8.11 in the familiar group. Table 3-3. Comparison of i ndividual beliefs before and af ter the discussion with pairwise conclusions. Panel A Panel B Panel C Personal Reports of Participants Before Discussion After Discussion Pair-wise Conclusions 6.9% 90.0% 3.1% Income Inventory Undecided 22.3% 73.1% 4.6% Income Inventory Undecided 72.3% 27.7% Inventory Income All Observations (n=130) 8.7% 88.7% 2.5% Income Inventory Undecided 26.2% 70.0% 3.8% Income Inventory Undecided 70.0% 30.0% Inventory Income ACG 4133 (n=80) 4.0% 92.0% 4.0% Income Inventory Undecided 16.0% 78.0% 6.0% Income Inventory Undecided 76.0% 24.0% Inventory Income ACG 5816 (n=50)

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44 Table 3-4. Comparison of auditor and c lient beliefs with pair-wise conclusions. Panel A Panel B Panel C Personal Reports of Participants After Discussion Auditors Clients Pair-wise Conclusions 15.4% 80.0% 4.6% Income Inventory Undecided 29.2% 66.2% 4.6% Income Inventory Undecided 72.3% 27.7% Inventory Income All Observations (n=130) 20.0% 77.5% 2.5% Income Inventory Undecided 32.5% 62.5% 5.0% Income Inventory Undecided 70.0% 30.0% Inventory Income ACG 4133 (n=80) 8.0% 84.0% 8.0% Income Inventory Undecided 24.0% 72.0% 4.0% Income Inventory Undecided 76.0% 24.0% Inventory Income ACG 5816 (n=50) Table 3-5. Number (percen tage) of observations in standards manipulation. Standards Principles Rules Total Inventory22 (34%) 25 (38%) 47 (72%) Joint Decision Income 11 (17%) 7 (11%) 18 (28%) Total 33 (51%) 32 (49%) 65 (100%)

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45 25 22 11 7 0 5 10 15 20 25 30 PrinciplesRules Inventory Income Figure 3-1. Standards manipul ation graph. The graph shows the effect of standards on the joint decision. Table 3-6. Number (percentage) of obs ervations in familiarity manipulation. Familiarity Familiar UnfamiliarTotal Inventory24 (37%) 23 (35%) 47 (72%) Joint Decision Income 9 (14%) 9 (14%) 18 (28%) Total 33 (51%) 32 (49%) 65 (100%) 23 9 24 9 0 5 10 15 20 25 30 UnfamiliarFamiliar Inventory Income Figure 3-2. Familiarity manipulation graph. The graph shows the effect of familiarity on the joint decision.

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46 Table 3-7. Number (per centage) of observations wh en the joint decision is INVENTORY. Familiarity UnfamiliarFamiliar Total Principles12 (26%) 10 (21%) 22 (47%) Standards Rules 12 (26%) 13 (28%) 25 (53%) Total 24 (51%) 23 (49%) 47 (100%) Table 3-8. Number (percenta ge) of observations when the joint decisions is INCOME. Familiarity UnfamiliarFamiliar Total Principles5 (28%) 6 (33%) 11 (61%) Standards Rules 4 (22%) 3 (17%) 7 (39%) Total 9 (50%) 9 (50%) 18 (100%) 10 13 12 0 2 4 6 8 10 12 14 UnfamiliarFamiliar Principles Rules Figure 3-3. Graph of Table 3-7. Joint decision is INVENTORY.

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47 6 3 5 4 0 1 2 3 4 5 6 7 UnfamiliarFamiliar Principles Rules Figure 3-4. Graph of Table 38. Joint decision is INCOME. Table 3-9. Manipulation check for the familiarity variable for individuals. The differences between unfamiliar and familiar treatment groups, based on the degree of familiarity reported by each participant (1=total stranger to 10=extremely familiar) were compared using a t-test. Unfamiliar Familiar Mean 6.53 8.11 Variance 5.08 5.44 Observations 66 64 Hypothesized Mean Difference 0 df 127 t Stat -3.92 P(T<=t) one-tail 0.000 P(T<=t) two-tail 0.000 Table 3-10. Manipulation check for the familiarity variable for paired individuals. The differences between unfamiliar and familiar treatment groups, based on the average degree of familiarity reported by each pair (1=total stranger to 10=extremely familiar) were compared using a t-test. Unfamiliar Familiar Mean 6.27 8.16 Variance 5.42 5.49 Observations 33 32 Hypothesized Mean Difference 0 df 63 t Stat -3.25 P(T<=t) one-tail 0.001 P(T<=t) two-tail 0.002

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48 Additional Variable: Compensation/Class The participants in the Intermediate Financial Accounti ng class (ACG 4133) received a grade that contributed to less that 1% of their total course grade for participating in the experiment whereas those students in the Professional Research class (ACG 5816) did not receive any compensation fo r participation. An additional binary variable for compensation was included in th e statistical analysis to control for any differential effects this may have on pair-w ise conclusions. However, the compensation variable is confounded with th e participants cla ss. The experiment setup fails to differentiate the effects of compensation from the effects of being enrolled in a different class. Hypothesis Tests The participants individual reports and pair-wise conc lusions were separately analyzed using logistic regression with pair-wise conclusions (1=INVENTORY and 0=INCOME) as the binary dependent variable and the factors familiarity, standards, and compensation as the independent variables. All the interaction variables were included in the initial analysis. The pair-wise analysis re sults were weaker acro ss all variables, since the sample size was reduced from 130 to 65 wh en the unit of observation is changed from individual observation to pair-wise obser vation. The probability modeled by the regression is based on the INCOME conclusion. The results of the logistic regression are reported in Table 3-11. The regression results indicate that the main effects of familiarity, standards, and compensation are all significant at the i ndividual observation base d analysis. Same analysis reveals significant two-way interactions between familiarity and standards, familiarity and compensation, and a borderlin e significant three-way interaction between

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49 all three variables. When each class is anal yzed separately using the same model, the results continue to hold for ACG5816 student s with regard to the main effects of standards and familiarity, and the two-way interaction between the two, but not for ACG4133 students (Table 3-11). Table 3-11. Logistic regression model for si ngle and pair-wise obs ervations explaining pair-wise conclusions. Pair-wise Observationsb Hypothesized SignFull Sample1ACG 58162 ACG 41332 Intercept ? 4.8832 (0.1323) 4.8835 (0.1323) -1.1938 (0.5423) Familiarity + -0.8698 (0.0397) -0.8699 (0.0397) 0.1026 (0.3386) Standards -6.9507 (0.0289) -6.9511 (0.0289) -1.3827 (0.3262) Compensation ? -6.0770 (0.1088) Familiarity5 x Standards6 ? 1.0261 (0.0625) 1.0262 (0.0625) 0.0519 (0.8917) Familiarity x Compensation7 ? 0.9724 (0.0791) Standards x Compensation ? 5.5679 (0.2442) Familiarity x Standards x Compensation ? -0.9742 (0.1460) Number of observations 65 25 40 -2 Log-likelihood statistic 68.702 22.237 46.465 Within-sample classification rate3 64.6 68 62.5 Paired rank correlation ("c" statistic)4 0.692 0.763 0.649 a Data collected based on individual observ ations was used to run the logistic regression. b Data collected based on pair-wise observ ations was used to run the logistic regression. 1 The analysis was run for the full sample with the pair-wise conclusion (INVENTORY and INCOME) as the binary dependent variable. The probability modeled by the regression is based on the INCOME conclusion. Reported values are parameter estimates from Logistic Regressions with p values of Wald chisquared statistics in parentheses. Reported p values for familiarity and standards variables are one-tailed. All other reported p values are two-tailed.

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50 2 The analysis was conducted separately for each sub-sample with the pair-wise conclusion (INVENTORY and INCOME) as th e binary dependent variable. The probability modeled by the regressions is based on the INCOME conclusion. Reported values are parameter estimates from Logistic Regressions with p values of Wald chi-squared statistics in parentheses. 3 This measure is a within-sample classification where each observation is classified as an event or non-event base d on the predicted probability from the logistic regression and then compared to wh at actually happens in the event status. 4 This measure compares all possible pairs of observations with different responses. It is said to be concordant (discordant) if the observation wi th the higher response has a higher (lower) predicte d probability than the lowe r level response. It is closest to a goodne ss-of-fit test. 5 Familiarity variable is a subjective measure of how familiar the participants felt with their partner and is included in th e analysis conducted at the individual observation level. A new familiarity variab le is calculated as the average of the subjective measures reported by the participan ts in each pair and is included in the analysis conducted at the pair-wise observation level. The familiarity variable is measured on a ten-point scale (1=total stranger to 10=extremely familiar). 6 Compensation variable is a binary meas ure coded as 1 for th ose participants in ACG4133 and coded as 0 for thos e participants in ACG5816. 7 Standards variable is a binary measur e coded as 1 for Rules-based standards and coded as 0 for Principles-based standards. The first hypothesis (H1) is th at the likelihood that a client agrees with an auditors position increases when the auditor and the clie nt resolve the issue using rulesrather than principles-based standards. The descri ptive statistics in Ta ble 3-5 and Figure 3-1 indicate that this relationship appears to hold. The main effect for standards was statistically ignificant thus providing strong support for H1. H1 is a one-directional test; therefore the reported p-values for standards variable are one-tailed. The analysis at each sub sample level reveals that the results for ACG 5816 participants continue to be statistically significant for standards. For ACG 4133, the main effect of standards becomes statisti cally insignificant, even though the parameter estimates sign is still in the same direction as the hypothesized sign. The familiarity variable is defined differently at individual and pair-wise level analysis. The logistic regression conducted at the indi vidual level employed the degree

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51 of familiarity reported by each participant as the familiarity variable. The same analysis conducted at the pair-wise level employed th e average degree of familiaritycalculated as the average degree of familiarity reported by subjects in the same pairas the familiarity variable in the analysis. The second hypothesis (H2) is that the more fa miliar an auditor is with a client, the more likely s/he is to agree with a clients positions. An inspection of the graphs in Figure 3-3 and Figure 3-4 indicates conflic ting results and sugge sts an interaction between familiarity and standards. The main effect for familiarity in the logistic regression (Table 3-11) is st atistically significant; however the sign is in the opposite direction from the hypothesized sign. Thus, the regression results suggest that a higher degree of familiarity reduces the likelihood of a client-favor ing outcome. This result may be due to the fact that all participants were accounting students and even though they were asked to play the role of the manager, they probably intrinsi cally reasoned with the mind of an auditor. Thus, the more familiar the pair was, the stronger was the intrinsic motivation to favor the auditors and not the managers position. H2 is a one-directional test; therefore the reported p-values for familiarity are one-tailed. The analysis at each sub sample level reveals that the results for ACG 5816 participants continue to be statistically significant for fam iliarity, but still in the opposite direction from the hypothesized sign. For ACG 4133, the main effect of familiarity becomes statistically insignificant, but the parameter estimates sign switches in the direction of the hypothesized sign. The significant interaction th at is observed in the full logistic regression model was further analyzed by splitting the sample into familiarity groups (Table 3-12). The logistic regression based on pair-wise observations did not reveal any significant results. Thus,

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52 the results for pair-wise anal ysis are not included. The interaction coefficient for standards and compensation was insignificant, th us the data was not further analyzed at class levels. The simple effect test for st andards reveals at borderline significance that when the auditor and the client are familia r with each other, discussing the ambiguous issue using rules-based (principles-based) st andards decreases the likelihood of a clientfavoring (auditor-favoring) outcome. This rela tion can be graphically observed in Figure 3-3 and Figure 3-4. On the other hand, when the auditor and the client were unfamiliar with each other, discussing the ambiguous i ssue using rulesor principles-based standards did not have any impact on the outcome of the resolution. The logistic regression was conducted usi ng sex, age, and academic level in the program entering as independent variables. None of these additional variables had an impact on the pair-wise conclusions. Thus, these results are not reported. Discussion and Limitations Results Discussion The analysis conducted at two sub sample of classes show considerable differences. A number of explanations can be enumerated for these differences. First of all, the differences in results may be attributed to the compensation provided for participating in the experiment to only one of the groups. Given the insignificance of the majority of results for this compensated group, it app ears that providing compensation randomized the data. This view is not consistent with the idea of providing compensation in the first place. Thus, there must be some other reas on to explain the insignificant results in one group and significant results in the other gr oup. A plausible explanation is accounting knowledge of students. ACG 5816 student s have already taken ACG 4133 as a prerequisite for enrolling in ACG5816. Thus, their accounting knowledge base can be

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53 considered greater than those enrolled in ACG4133. Johnstone, Bedard, and Biggs (2002) suggest that higher task knowledge aud itors may be better prepared to interact with aggressive, uncooperative clients. They show that inherited alternatives prohibit generation of alternative solutions among lowe r knowledge auditors. This may very well explain the discrepancy of outcomes between the two groups of students. Table 3-12. Logistic regression for simple eff ects test for familiarity using data collected at individual level. Familiarity Treatment Hypothesized SignWith Interaction1 Simple Effects2 Intercept ? -0.5108 (0.1618) -0.5108 (0.1618) Standards5 -1.0986 (0.0998) -0.9555 (0.1005) Standards x Compensation6 ? 0.2231 (0.8153) Number of observations 64 64 -2 Log-likelihood statistic 73.170 73.225 Within-sample classification rate3 71.9 71.9 Paired rank correlation ("c" statistic)4 0.621 0.616 Unfamiliarity Treatment Hypothesized SignWith Interaction Simple Effects Intercept ? -0.8755 (0.0200) -0.8755 (0.0200) Standards5 0.1823 (0.7998) -0.2231 (0.6878) Standards x Compensation6 ? -0.6931 (0.4032) Number of observations 66 66 -2 Log-likelihood statistic 76.487 77.184 Within-sample classification rate3 72.7 72.7 Paired rank correlation ("c" statistic)4 0.565 0.528

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54 1 The analysis was run for the full sample with the pair-wise conclusion (INVENTORY and INCOME) as the binary dependent variable splitting on familiarity. The probability modeled by the regression is based on the INCOME conclusion. Reported values are paramete r estimates from Logistic Regressions and those in parentheses are one-tailed p values for standards and two-tailed p values for other parameter estimates of Wald chi-squared statistics. 2 The analysis was run for the full sample with the pair-wise conclusion (INVENTORY and INCOME) as the binary dependent variable splitting on familiarity to test for simple effects of standards. The probability modeled by the regression is based on the INCOME conclusion. Repor ted values are parameter estimates from Logistic Regressions with p values of Wald chi-squared statistics in parentheses. 3 This measure is a within-sample classification where each observation is classified as an event or non-event base d on the predicted probability from the logistic regression and then compared to wh at actually happens in the event status. 4 This measure compares all possible pairs of observations with different responses. It is said to be concordant (discordant) if the observation wi th the higher response has a higher (lower) predicte d probability than the lowe r level response. It is closest to a goodne ss-of-fit test. 5 Standards variable is a binary measur e coded as 1 for Rules-based standards and coded as 0 for Principles-based standards. 6 Compensation variable is a binary meas ure coded as 1 for th ose participants in ACG4133 and coded as 0 for thos e participants in ACG5816. Another factor that may have produced the differences in results is the level of authority present in the classroom while th e experiment was conducted. The professor was personally present when the experime nt was administered to ACG5816 students whereas a teaching assistant, who was a gradua te student, was initia lly present and then left the classroom while the experiment wa s administered to ACG4133 students. This could suggest that the students in ACG5816 (more knowledgeable compared to those in ACG4133 and working under the presence of an authorityalbeit without any compensation for participation) took the expe riment far more seriously than the other group. One could possibly infer that the credibility of the results from ACG5816 students are further enhanced by these uncontrolled and unfores een factors that existed at

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55 the time the experiment was conducted. Inte rpreted this way, the data obtained from ACG4133 students could be viewed as a dding random noise to the analysis. The comparison of individual beliefs with pair-wise conclusions (Figure 2 and Figure 3) illustrate that the outcome of conflict resolution cl osely reflects the beliefs of clients. This could mean that auditor independence is truly impossible (Bazerman, Morgan, Loewenstein, 1997). This pattern clearly reflects Antle and Nalebuffs (1991) claim that joint conclusions of auditor and client are always clie nt-favored. Figure 2 shows that the initial beliefs of participan ts before they discuss the issue are not associated with their privately reported beliefs and the outcome of the resolution after they have discussed the issue. Gibbins et al. (2001) also report ed that they found no association between the reported initial beliefs of the parties and the contextual features, when beliefs are considered very im portant in basic negotiation models. Limitations One major limitation of the experiment is that the selected sample was initially biased towards the auditor-favored conclusion. This was because all participants were accounting majors. Nonetheless, comparison of initial beliefs with pair-wise conclusions still display differences, indi cating that even asking accounti ng students to role-play as clients has an impact on the outcome of the conflict resolution. However, because the sample was initially biased towards one side, this naturally produced pair-wise conclusions that were also biased towards the same side, weakening th e statistical results. The pairs were provided with only one acc ounting standard to defend their point of view. In reality, a variety of accounting standards are used to justify a certain reporting decision and this set of standards will include bo th rulesand principles-based standards. Thus, the results of the experi ment are not immediately genera lizable to other settings.

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56 An important factor to reflect upon is that the standard set ting process is a process and that standards are not a static set over time. Significant efforts should be made to continue progress in the development of objectiv es from this point on. The objectives of financial statements are not and should not be static. (report of the Accounting Objectives Study Group, 1973, p. 44). Majority of the subjects in the experime nt had been in the program long enough to know most about everybody in their class. Hence, even though the familiarity manipulation seems to have worked to a cert ain degree, the results should be interpreted with caution. Instructing people to assume that they do not know somebody when they actually do is tricky. This can possibly e xplain why there were no significant results associated with the unfamiliar group. A further limitation of the study is that th e experimental design did not take into consideration potentially important factors in negotiation such as the bargaining/discussion strategies of subjects, first mover advantage, additional information added into the setting by the participants, and the degree of effort each participant put into the discussion. In the real world, there are many other fact ors that enter a nego tiation process, each factor interacting to a certain degree with all th e other factors. Even in this small study, it was documented that most of the interactions between the variables were significant. Hence, the results of this study should be taken with a grain of salt for the simple fact that there are at least a dozen missing variables from the equation.

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57 CHAPTER 4 CONCLUSION The principle of conservatism is an impor tant feature of the financial reporting system. There have been numerous empiri cal attempts to measure the extent of conservatism embedded in the financial statem ents. Chapter 2 discusses these different measures and the results of the empirical studies in light of a simple model that attempts to explain the conflicting results of bala nce sheet based and income statement based conservatism measures. The model explains why increased income statement based conservatism may be associated with decrease d balance sheet based conservatism. I also distinguish between growth a nd no-growth firms and argue that the difference between the two measures cannot be interpreted adequately given increased growth. Additional empirical analysis is needed to test the model. An empirical study can be conducted using a proxy for growth and forming portfo lios based on growth and then measuring the degree of conservatism on the balance sheet and the income statement. One very important conclusion that emerges from chapter 2 is th at there is not a single measure of conservatism. There are ma ny factors to consider and any simplistic way of attempting to measure conservatism cannot be relied upon to draw conclusions about the degree of conservatism inherent in financial reporti ng. Other than quantitative factors, there are qualitative factors th at interfere when making decisions under uncertainty. Prudence for example, a subj ective concept, is deemed conservative behavior (Giner and Rees, 2001). Thus, the v alue of an increment of prudence or the level of prudence may differ greatly across companies and across countries.

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58 Chapter 3 explores the effects of two qualitative factors that may influence conservatism in financial reporting. A uni que setting is chosen to explore how the resolution of an ambiguous accounting issue be tween the auditor and the client can be affected by employing different types of standards and whether the degree of familiarity between the auditor and the client impact s the outcome of the resolution. The experimental design is based on the threeelement process model of auditor-client accounting negotiation proposed by Gibbins et al. (2001). Th e results indicate that the type of standards and the degree of familiarity jointly have an effect on conflict resolution. Thus, the joint d ecision of two parties that have a conflict of interest will ultimately affect the degree of conservatism in the reported numbers. Hence, conservatism is an elusive concept difficult to operationalize with simple quantitative measures that lack contextual f actors. Any empirical studies that claim to report on the degree of conservatism in fina ncial reporting have to be analyzed and interpreted with great cauti on before drawing conclusions.

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59 APPENDIX HISTORICAL PERSPECTIVE ON THE DEVELOPMENT OF ACCOUNTING STANDARDS 1929 Market Crash and the Development of Accounting Standards The Securities and Exchange Commission (SEC) was formed to restore public confidence in the capital market s after the stock market crash in 1929. The main purpose of the SEC was to build investors trust by ensuring that the companies truthfully conveyed information about th emselves to the public [http://www.sec.gov/about/whatwedo.shtml]. The only way this could be done and monitored at the same time was creating re gulations that would make the companies report truthfully. Regulation is possible thr ough the formation of a police force of some kind that will enforce a set of rules. The SEC would be the police force and the set of rules needed to be created. At the time, accounting standards were not heard of, so the SEC encouraged the creation of a group of st andard setters. In recognition of the resources, expertise, and talent of the priv ate sector, the SEC suppor ted the formation of a private standard-setting body and asked the Am erican Institute of Accountants (later AICPA) to undertake the task of providing accounting standards for companies (Kieso, Weygandt, and Warfield, 2001). The AICPA appointed a small group of pr ominent academics, Sanders, Hatfield, and Moore, to write the accounting standa rds and published their work in 1938: A Statement of Accounting Principles which is the first not eworthy book of accounting standards. In the Introduction section of the book, the au thors stated that several institutions had already issued various sets of accounting st andards. For example, the

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60 AICPA had published a brief st atement of principles, th e SEC had issued accounting regulations for the administration of the legisl ation, and the Bureau of Internal Revenue had enlarged the volume of its accounting rules for determining taxable income. However, none of the issued statements represented a complete formulation of accounting principles. It seemed that each agency was stating only those accounting rules that required compliance with the statut es it was administering. Thus, the time seemed ripe for the compilation of a compre hensive statement of accounting principles. The authors, not being members of the AICP A but notable academics, had been asked to carry out the task of writing the standards on behalf of the Institu te yet independently from the Institute. This appeared to be a perfect arrangement for the AICPA: it encouraged research without lending authority to its findings. On the other hand, the SEC was not satisfied with the arrangement a nd urged the Institute to back their findings and endorse their principles, which led to the formation of the Committee on Accounting Procedure (CAP) in 1939 (Baxter, 1979). CAP issued 51 authoritative standards known as Accounting Research Bulletins (ARB) from 1939 to 1959. ARBs were i ssued in response to accounting problems occurring at the time. The ARBs had a big impact on the financial reporting system and constituted the basis of generally accept ed accounting principles (GAAP), but the problem-by-problem approach to formulating standards failed to provide the desired structured body of accounting standards (Kieso et. al, 2001). All CAP members worked part-time. There was not enough staff and the turnover ratio was high. The critics pointed out that the committee did not rely enough on research and that it was the catspaw of the SEC. Thus, came the demi se of CAP and the formation of a new committee: the Accounting Princi ples Board (Baxter, 1979).

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61 The Accounting Principles Board (APB), run by about 20 part-time members, replaced CAP in 1959. After a decade of its formation, criticisms began to pour in once more: APB was considered to be lacking th e resources necessary to develop high-quality standards to meet the increasingly complex business transactions of the times [http://www.aicpa.org/info/r egulation02.htm]. The development of a conceptual framework was a principal part of the char ter of the APB in 1958 (Burton, 1978). Yet, there were complaints about the lack of articulated statements of basic concepts underlying procedures that would enable uni formity, simplicity, and comparability in financial reporting. There wa s a longing for certainty that could only be provided by a coordinated system of principles (Davidson, 1969). APBs failure to provide such a conceptual framework has been cited as one of the main reasons that eventually led to its replacement by the Financial Accounting St andards Board (FASB) in 1973 (Burton, 1978). By the time APB was terminated, it had issued 31 standards called APB Opinions. Blue Monday and the Emerging FASB Trueblood (1970) observed that there were rising expectations in all fields including accounting mostly be cause of the advances in technology and communications at the time. He pointed out that increas ed personal and social choices, business alternatives, interdependence, and the rising costs accompanying the choices would likely intensify the moral and ethical problems that already existed in the accounting profession. He called for rules for the profession so that the accountants could not find ways to circumvent APB Opinions that their clients di d not like. He stated that the profession must move to correct deficiencies in the setti ng of standards with more alacrity than it has so far seemed able to muster (p. 38).

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62 Truebloods observations and recommenda tions for the accounting profession closely follow the market crash of 1969. In 1971, in the aftermat h of the crash, the AICPA appointed a Study Group on Establishm ent of Accounting Principles (commonly known as the Wheat Committee). This was an action similar to the one that AICPA undertook after the 1929 crash when the AICPA appointed academics to write standards on behalf of the Institute. The Study Gr oups recommendations were submitted to the AICPA Council in 1972, adopted in total, a nd shortly after implemented in 1973. As a result of the Wheat Comm ittees recommendations, the APB was disbanded and the FASB was founded (Kie so et. al, 2001). The Study Groups conclusions were base d upon the fundamental concept that financial statements should aid economic deci sion-making. All the major conclusions of the Group aimed for a principles-based appr oach to standard setting. Emphasize substance, not technical form was explicitly listed as one of the conclusions (Report of the Accounting Objectives Study Group, 1973). Hence, the Wheat Committee initially started out with a principles-bas ed approach to standard setti ng just like all the previous committees that undertook the task. The FASB started its operations by implementing the Trueblood report and formulating a conceptual framework for the profession, which the CAP and the APB had failed to do. This conceptual framew ork would provide the basis upon which new standards could be issued (Flegm, 1989). Flegm (1989) describe d the FASBs next decade full of tension but nonetheless revolu tionary as the committee proceeded on the conceptual framework project. The Di scussion Memorandum (DM) published in 1976 supported a shift from the matching of costs a nd revenues perspective to an asset/liability

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63 view when determining income. Two public hearings were held in 1977 and 1978 to discuss the DM and the perceived shift in income determination. In 1978, Flegm (1989) attended a special m eeting of the FASB on the conceptual framework project and the DM. The meeting entailed the discussion of eight examples of accounting problems with th e participants being asked to1 comment on whether or not they accepted the various alternatives under the asse t/liability or revenue/expense2 view. Without delving extensivel y into the discussion, it is fa ir to say that there was little consensus on any of the issues (p. 91). Th e author stated that despite the lack of consensus, the FASB was determined to implement the Trueblood report, which was geared toward the asset/liability view of income and entailed the prediction of future cash flows and fair value accounting. On the other hand, accountants led by Financial Executives Institutes (FEI) Committee on Corporate Reporting, argued for the maintenance of the historical-cost based accounting and the retention of the matching concept (p. 91). Flegm pointed out that this fundamental argu ment had not been resolved when the concepts statements were being de veloped, which eventually led to so many compromises that in the end no one ha s been satisfied with the result. To assist the FASB in the development of a conceptual framework, the AICPA, Financial Analysts Federation, FEI, and the Robert Morris Associates got together to discuss the issue in the trie nnial Seaview Symposium (Burton, 1978). The group shared the general view that financial statements s hould be limited to objectiv ely verifiable data 1 Asset/liability perspective considers assets and lia bilities to be direct measurements of economic phenomena and defines income as a change in such phenomena. This view endorses the fair-value approach to accounting (Burton, 1978). 2 Revenue/expense perspective considers assets and lia bilities to be residuals arising out of the income measurement process. This view endorses the historical cost approach to accounting (Burton, 1978).

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64 and objectivity should not be compromised for better predictive information. However, there were differences of opinion on how far the process of emphasizing objectivity should go. Some supported the notion of moving towards a more cash-basis accounting, whereas others, including the FASB, prefe rred an accrual-basis accounting but at the same time were in favor of objective meas urements that would minimize managements role in income determination. The cons ensus was that the financial statements themselves should not emphasize predictive da ta, yet a predictive approach to financial reporting should be undertaken outside the financial statements to aid users of information in decision-making about companie s. The group proposed that predictive data, subject to uncertainties and differences in subjective opinion, s hould appear under a separate section of the financ ial report and not be audited as rigorously as the financial statements. This way the statements would be simpler, more uniform, more understandable and less subject to manipulati on. A small group was concerned because of added constraints to the conceptual framework project and objected to an implementation of the dual report ing approach. (Burton, 1978). 1980s: How (and Why) did We Move Away from Principles-Based Approach to Standard Setting toward a Rules-Based Approach? In the 1980s, the search for a conceptual framework to guide the FASB in decision making was still a lingering issue. Accounting Principles Board Statement no. 4, Basic Concepts and Accounting Prin ciples Underlying Financia l Statements of Business Enterprises, was perceived as helpful in de fining objectives, but nevertheless considered insufficient in prescribing a clear direction for standa rd setting (Kirk, 1981). Horngren (1981) observed that the FASB wa s moving in the dire ction of building a conceptual framework that emphasized the t echnology of accounting. He explained that

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65 this was because of a problem of social choice. A technical fr amework would empower the FASB by measuring the financial impact of events in an evenhanded manner and thus steer the board away from the probl em of social choice. For the FASB, this problem entailed the identif ication of the constituencies in power, acting in accordance with their wishes and accomplishing this in a manner that would be acceptable by the 800-pound gorilla in the form of the federal gove rnment, particularly the SEC in order to ensure its survival. The emphasis on certain issues would still continue to depend on the relative importance of the boards cons tituencies, but building a more technical framework would enable the FASB to st ay away from the policymaking process (Horngren, 1981, p. 88). In the beginning of the 1980s, the ac counting profession had already begun complaining about a standards overload (Chenok et. al, 1980). Not heeding the protests of the profession, the FASB embarked on a journey of moving away from principlesbased toward rules-based standards. Th e motivation behind this apparent course of action was to empower the FASB help drive out creative accounting that emerged as executive pays were increasingly tied to repor ted profits and as new and riskier ways of financing appeared as a result of globaliz ation and deregulation (Piecara, 2002). Sterlings captivating desc ription of the accountants dilemma (1973) closely parallels the FASBs problem in the 1980s a nd why the board opted to move toward a more rules-based approach to standard setting: As an independent auditor, the accountant needed a strong defense against the always optimistic, sometimes dishonest, financie rs and entrepreneurs. Unfortunately, he was not given this defense. Instead, he was placed in the precarious position of being the employee of the person he was obliged to keep honest. In the absence of a cohesive

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66 theory, in the absence of police power, in the presence of ignorance and apathy of the community, his only defense was precedent and persuasion. Precedent soon became rule and the rigid application of rules was his pr imary weapon. It is much easier and more diplomatic to accuse someone of breaking a rule than to accuse him of telling a lie (p. 61). The Nature of Standards in 1980s, EITF, and More Rigid Rules The Emerging Issues Task Force (EITF) was established in 1984 upon the FASBs recommendations to form a group responsible for timely financial reporting guidance in order to assist with emerging accounting problems [http://www.fasb.org/eitf]. The task force did not have any formal authority, yet its views quickly became to be regarded as de facto GAAP for managers and accountants who wanted timely guidance on new issues (Wishon, 1986). In less than two years time after its formation, the EITF fueled the lively debate on whether standards should be general or specific (Wishon, 1986). Despite advocates for broad and general st andards, who believed detailed questions should be dealt by managers, the task for ces having reached a consensus on almost 50 issues in its first 20 months was clear evidence that those who supported detailed standards had won the latest round on the long-debated issue (Wishon, 1986). Black Monday and the Troubled FASB There were major changes in the compositi on of the FASB right before the market crash in 1987 (Flegm, 1989). The publication of a White Paper sponsored by the FEI and the Accounting Principles Task Force suggested an increase in busin ess-trained people on the FASB and the trustees of the Financ ial Accounting Foundati on (FAF), which was followed by the appointment of Art Northr op and Vic Brown (both with primarily a business background) to the FASB. This ra ised considerable controversy in the

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67 accounting field with some believing it to be an attempt by business to take over the standards-setting process. The resignati on of Art Wyatt in mid-1987 because of the increased influence of busine ss in the FASBs activities was the ultimate peak of the controversy. As the disput e subsided following the appoint ments of Jim Leisenring and Clarence Sampson to the FASB, and by the time the virtual reformation of the Board was complete in 1987, there was yet another market crash: the Black Monday. This time the reformation of the standard-setting committee co incided with the collapse of the financial market. Hence, this was the FASBs opportunity to start afresh with the financial market in the aftermath of the crash. The Tech Bubble and the Proposed Shi ft from Rules-based to Principlesbased Standards History seems to repeat itself as we once again embark on a search to improve the financial reporting system after yet another market crash: the burst of the tech bubble. The desirable shift is this time towards a mo re principles-based approach to accounting standards as called forth by the Sarbanes-Oxl ey Act to which the FASB has responded by issuing a Proposal for a Prin ciples-Based Approach to U.S. Standard Setting (FASB 2002).

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68 LIST OF REFERENCES Antle, R., and B. Nalebuff. 1991. Conser vatism and auditor-client negotiations. Journal of Accounting Research 29 (Supplement): 31-54. Asare, S. K., and L. S. McDaniel. 1996. Th e effects of familiarity with the preparer and task complexity on the effectivene ss of the audit review process. The Accounting Review 71 (April): 139-159. Ball, R., S. P. Kothari, and A. Robin. 2000. The effect of international institutional factors on properties of accounting earnings Journal of Accounting and Economics 29: 1-51. Barth, M. E., W. H. Beaver, and W. R. La ndsman. 2001. The relevance of the value relevance literature for financial accounti ng standard setting: Another view. Journal of Accounting and Economics 31: 77-104. Basu, S. 1997. The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics 24: 3-37. Basu, S. 2001. Discussion of On the asym metric recognition of good and bad news in France, Germany and the United Kingdom. Journal of Business Finance & Accounting 28 (9/10): 1333-1349. Bazerman, M. H., K. P. Morgan, G. F. Loewen stein. 1997. The impossibility of auditor independence. Sloan Management Review 38 (4): 89-94. Beaver, W. H. 1998. Financial reporting: An accounting revolution. Upper Saddle River, NJ: Prentice Hall Beaver, W. H., and S. G. Ryan. 2000. Biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity. Journal of Accounting Research 38 (1): 127-148. Begley, J., and R. Freedman. 2004. The cha nging role of accounti ng numbers in public lending agreements. Accounting Horizons 18 (2): 81-96. Bowen, R. M., L. DuCharme, and D. Shores. 1995. Stakeholders implicit claims and accounting method choice. Journal of Accounting and Economics 20 (3): 255295.

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69 Brasil, Jr., and S. Meira. 2001. Rules and principles in legal reasoning. A study of vagueness and collisions in artificial intelligence and law. Information and Communications Technology Law 10 (1): 67-77. Brealey, R. A, S. C. Myers, and A. J. Marc us. 2001. Fundamentals of Corporate Finance Third Edition: McGraw-Hill Irwin. Burton, J. C. 1978. A symposium on the conceptual framework. Journal of Accountancy 145 (1): 53-58. Chenok, P. B., D. R. Carmichael, and T. P. Kelly. 1980. Accounting and auditing: The technical challenges ahead. Journal of Accountancy 150 (5): 62-70. Committee on Accounting Procedur es (CAP), AICPA. 1953. Accounting Research Bulletin No. 43: Restatement and Revisi on of Accounting Research Bulletins, Chapter 4 Paragraph 3-5 Cuccia, A. D., K. Hackenbrack, M. W. Nels on. 1995. The ability of professional standards to mitigate aggressive reporting. The Accounting Review 70 (2): 227248. Davidson, S. 1969. Accounting and fina ncial reporting in the seventies. Journal of Accountancy 128 (6): 29-37. Devine, C. T. 1963. The rule of conservatism reexamined. Journal of Accounting Research 1 (2): 127-138. Dopuch, N., R. R. King, and R. Schwartz. 2001. An experiment al investigation of retention and rotation requirements. Journal of Accounting Research 39 (1): 93117. Fama, E. F., and K. R. French. 1998. Value versus growth: The in ternational evidence. Journal of Finance 53 (6): 1975-1999. _____. 1995. Size and book-to-market f actors in earnings and returns. Journal of Finance 50 (1): 131-155. Farmer, T. A., L. E. Rittenberg, and G. M. Tr ompeter. 1987. An investigation of the impact of economic and organizational factors on audito r independence. Auditing: A Journal of Practice & Theory 7 (1): 1-14. Feltham, G., and J. A. Ohlson. 1995. Va luation and clean su rplus accounting for operating and financial activities. Contemporary Accounting Research 11 (2): 689-731. Financial Accounting Standard Board (FASB). 1980. Statement of financial accounting concepts No.2: qualitative characte ristics of accounting information Norwalk, CT: FASB.

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70 __________. 1981. Statement of Financial Accounting Standards No. 45: Accounting for Franchise Fee Revenue, Paragraph 5 Stamford, CT: FASB. __________. 1985. Statement of Financial Accounting C oncepts No. 6: Elements of Financial Statements, Paragraph 79 Stamford, CT: FASB. __________. 2002. Proposal: Principles-based approach to U.S. standard setting File Reference No. 1125-001. Norwalk, CT: FASB. Flegm, E. H. 1989. Commentary on the limitations of accounting. Accounting Horizons 3 (3): 90-97. Gibbins M. 2002. Discussion of Evidence from auditors about managers and auditors earnings management decisions. The Accounting Review 77 (Supplement): 203211. Gibbins, M., S. McCracken, and S. Salterio. 2003. Evidence about auditor-client management negotiation concerning client s financial reporting: The chief financial officer perspective. Working Paper. Gibbins, M., S. Salterio, and A. Webb. 2001. Evidence about auditor-client management negotiation concerning client s financial reporting. Journal of Accounting Research 39 (3): 535-563. Gigler, F. B., and T. Hemmer. 2001. Conser vatism, optimal disclosure policy, and the timeliness of financial reports. The Accounting Review 76 (4): 471-493. Giner, B., and W. Rees. 2001. On the as ymmetric recognition of good and bad news in France, Germany and the United Kingdom. Journal of Business Finance & Accounting 28 (9/10): 1285-1331. Givoly, D., and C. Hayn. 2000. The changi ng time-series properties of earnings, cash flows and accruals: Has financial repo rting become more conservative? Journal of Accounting and Economics 29 (3): 287-320. Givoly, D., C. Hayn, and A. Natarajan. 2003. Measuring reporting conservatism. Working Paper. Smeal College of Business, Pennsylvania State University, The Anderson School Graduate School of Manage ment, University of California Los Angeles, and California St ate University Pomona. Glazer, A. S., and H. R. Jaenicke. 2002. A pathology of the Independence Standards Boards Conceptual Framework Project. Accounting Horizons 16 (4): 329-352. Hackenbrack, K., and M. W. Nelson. 1996. A uditors incentives and their application of financial accounting standards. The Accounting Review 71 (1): 43-59.

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71 Holthausen, R. W., and R. L. Watts. 2001. The relevance of the value-relevance literature for financial acc ounting standard setting. Journal of Accounting and Economics 31: 3-75. Horngren, C. T. 1981. Uses and limitations of a conceptual framework. Journal of Accountancy 151 (4): 86-95. Johnstone, K. M., J. C. Bedard, and S. F. Bi ggs. 2002. Aggressive client reporting: Factors affecting auditors generation of financial reporti ng alternatives. Auditing: A Journal of Practice & Theory 21 (1): 48-65. Kachelmeier, S. J. 1996. Discussion of Tax advice and reporti ng under uncertainty: Theory and experimental evidence. Contemporary Accounting Research 13 (1): 81-89. Kieso, D. E., J. J. Weygandt, and T. D. Warfield. 2001. Intermediate accounting volume 1 New York: John Wiley & Sons, Inc. Kirk, D. J. 1981. Concepts, consensus, co mpromise and consequences: their roles in standard setting. Journal of Accountancy 151 (4): 83-86. Lara, J. M. G., and A. Mora. 2004. Balan ce sheet versus earnings conservatism in Europe. European Accounting Review 13 (2): 261-292. Magee, R. P., and M Tseng. 1990. Audit pricing and independence. The Accounting Review 65 (2): 315-336. Mayhew, B. W., J. W. Schatzberg, and G. R. Sevcik. 2001. The effect of accounting uncertainty and auditor reputat ion on auditor objectivity. Auditing: A Journal of Practice & Theory 20 (2): 49-70. Nelson, M. W. 2003. Commentary on Behavior al evidence on the eff ects of principlesand rules-based standards. Accounting Horizons 17 (1): 91-104. Nelson, M. W., J. A. Elliott, and R. L. Tarp ley. 2002. Evidence from auditors about managers and auditors earnings management decisions. The Accounting Review 77 (Supplement): 175-202. Pae, J., D. B. Thornton, and M. Welker. 2004. The link between earnings conservatism and balance sheet conservatism. Wo rking Paper, Queens University. Penman, S. H., and X. Zhang. 2002. Acc ounting conservatism, the quality of earnings, and stock returns. The Accounting Review 77 (2): 237-264. Piecara, S. 2002. Accounting: the stat e of the profession. Presentation at CFC Independent Borrowers Conference November 15, 2002

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72 Pope, P. F., and M. Walker. 1999. International differences in the timeliness, conservatism, and classification of earnings. Journal of Accounting Research 37 (Supplement): 53-87. Pownall, G., and K. Schipper. 1999. Impli cations of accounting research for the SECs consideration of internationa l accounting standards for U.S. securities offerings. Accounting Horizons 13 (3): 259-280. Ramsay, R. J. 1994. Senior/Manager differences in audit workpaper review performance. Journal of Accounting Research 32 (Spring): 127-135. Report of the Accounting Obj ectives Study Group. 1973. Journal of Accountancy 136 (15): 43-44. Salterio, S, and L. Koonce. 1997. The pers uasiveness of audit evidence: The case of accounting policy decisions. Accounting, Organizations and Society 22 (6): 573587. Sanders, T. H., H. R. Hatfield, and U. Moore. 1938. A statement of accounting principles New York: American Institute of Accountants. Schipper, K. 2003. Principles-based accounting standards. Accounting Horizons 17 (1): 61-72. Securities and Exchange Commission. Of fice of the Chief Accountant. 1999. Staff Accounting Bulletin: No. 101Revenue Recognition in Financial Statements Washington, D.C.: SEC. Sterling, R. R. 1973. Accounting Power. Journal of Accountacy 135 (1): 61-67. Tan, H., and K. Jamal. 2001. Do auditors ob jectively evaluate thei r subordinates work? The Accounting Review 76 (January): 99-110. Trueblood, R. M. 1970. Rising expectations. Journal of Accountancy 130 (6): 35-38. Vincent, L., L. A. Maines, E. Bartov, P. Fa irfield, D. E. Hirst, T. E. Iannaconni, R. Mallett, C. M. Schrand, and D. J. Sk inner. 2003. Commentary on Evaluating concepts-based vs. rules-based ap proaches to standard setting. Accounting Horizons 17 (1): 73-89. Wallace, W. A. 1988. The irony of responding to regulators pressures: The case of management letter precau tionary representations. Accounting Horizons 2 (March): 88-93. Watts, R. L. 2003a. Conservatism in accounting part I: Explanations and implications. Accounting Horizons 17 (3): 207-221.

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73 _____. 2003b. Conservatism in accounting part II: Evidence and research opportunities. Accounting Horizons 17 (4): 287-301. Wilks, T. J. 2002. Predecisional distortion of evidence as a cons equence of real-time audit review. The Accounting Review 77 (January): 51-71. Wishon, K. 1986. Plugging the gaps in GAAP: the FASBs Emerging Issues Task Force. Journal of Accountacy 161 (6): 96-105. Zeff, S. A. 2003a. How the U.S. accounting pr ofession got where it is today: Part I. Accounting Horizons 17 (3): 189-205. _____. 2003b. How the U.S. accounting professi on got where it is t oday: Part II. Accounting Horizons 17 (4): 267-286. Zhang, X. 2000. Conservative accounting and equity valuation. Journal of Accounting and Economics 29: 125-149.

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74 BIOGRAPHICAL SKETCH I was born and raised in Adana, Turkey. I graduated from Bogazici University in Istanbul, Turkey, with a Bachelor of Arts in business administration in June 1993. I received a Master of Educati on in educational psychology from the University of Florida in 2000. Currently, I am working towards a Master of Arts degree in economics.