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FINANCIAL STATEMENT PREPARERS REVENUE DECISIONS: ACCURACY INAPPLYING RULES-BASED STANDARDS AND THE IASB-FASB REVENUE

RECOGNITION MODEL

ByMary McCarthy

A DISSERTATION

Submitted to theH. Wayne Huizenga School of Business and Entrepreneurship

Nova Southeastern University

in partial fulfillment of the requirements

for the degree of

DOCTOR OF BUSINESS ADMINISTRATION

2012


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ABSTRACT

FINANCIAL STATEMENT PREPARERS REVENUE DECISIONS: ACCURACY INAPPLYING RULES-BASED STANDARDS AND THE IASB-FASB REVENUE

RECOGNITION MODEL

by

Mary M. McCarthy

U.S. GAAP and the software industry in particular, are on the verge of a major

alteration in revenue-recognition accounting standards. The IASB-FASB joint revenue-

recognition project is due to be finalized over the next year with the result being a shiftfrom a rules-based set of accounting standards to a principles-based standard. The

purpose of this research is to examine financial statement preparers software revenue-

recognition decisions under a principles-based accounting standard compared to a rules-based accounting standard both with and without a personal incentive to maximize

revenue. The 2 X 2 between-subjects experiment examines the revenue-recognition

judgments and decisions of financial statement preparers involved in applying rules-

based standards (U.S. GAAP) and a principles-based standard (IASB-FASB ExposureDraft:Revenue from Contracts with Customers) with and without a personal incentive to

maximize revenue. The study included 127 experienced financial statement preparers

with an average of 20 years of experience and 82% at a manager/director level or above.

The results indicate financial statement preparers applying rules-based standards

in a revenue-recognition scenario provide less accurate revenue decisions than when

applying a principles-based standard. Moreover, the results did not show that a personalincentive influenced the financial statement preparers in their revenue-recognition

decisions. Surprisingly, in the rules-based and principles-based scenarios where a

personal incentive was not present, the arithmetic mean recommended revenue amountswere higher. In providing the amount of judgment required to determine the revenue to

be recognized, there was not a statistically significant difference in the amount of

judgment required between subjects applying rules-based standards and subjects applyingprinciples-based standards. The arithmetic means for rules-based subjects and principles-

based indicated some judgment however not significant judgment was required. This is

interesting to note as so few subjects correctly answered the revenue amount and

neglected to fully apply the guidance.


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ACKNOWLEDGEMENTS

Most importantly I would like to thank my husband Richard for his continuous

support to pursue my doctoral degree. His persistent encouragement every step of theway ensured my pursuit for a doctoral degree was a success. In addition, I would like toexpress my appreciation for the many sacrifices he made that permitted me the time to

put towards this effort. Words cannot express my unending love for you. I would like to

acknowledge my children, Kathryn, Andrew, and Colleen. Thank you for your supportand encouragement over the past several years.

I am indebted and extremely grateful for my dissertation committee. I would like

to express my sincere appreciation to my chairperson, Dr. Randall Rentfro, for taking thetime early in my doctoral studies to read my concept paper and encourage me to pursue a

behavior-based study. Dr. Rentfro, I appreciate all the feedback, guidance, and

encouragement you have provided along the way. I would also like to thank and expressmy appreciation to my other committee members, Dr. Cynthia Ruppel and Dr. Paul

Mihalek. Dr. Ruppel, thank you for your constructive feedback throughout the process. I

have learned a great deal. Dr. Mihalek, thank you for your support, encouragement, and

guidance both with my dissertation and my first year of teaching. To all my committeemembers, thank you.

Thank you to all my professors in the doctoral program. I thoroughly enjoyed theprogram at Nova Southeastern University. Lastly, I would like to convey my appreciation

to my colleagues at Central Connecticut State University. I am grateful for the

opportunity you have provided to me.


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vi

TABLE OF CONTENTS

Page

List of Tables.. viii

List of Figures. ix

List of Graphs. x

Chapter

I. INTRODUCTION.. 11

Purpose of the Study and Research Questions.. 12Background and Justification 13

Summary. 24

II. REVIEW OF THE LITERATURE 24

Pros and Cons of Principles-based and Rules-basedStandards

24

Judgment and Decision Making. 28Prior Research Examining Principles-based Standards Versus Rules-based Standards..

30

Revenue-Recognition Accounting Standards and Prior

Research..33

Incentives-based and Motivation-based Theories.. 38

III. METHODOLOGY. 52

Experimental Instrument 52Data Collection........................... 54Experimental Procedures and Task 56Research Design and Variables.. 58

IV. ANALYSIS AND PRESENTATION OF FINDINGS.. 60

Introduction 60Demographics. 60Hypotheses and Statistical Analysis.......................... 69Familiarity with Standards. 75Summary. 77


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V. SUMMARY AND CONCLUSION.......................... 79

Research Findings.......................... 79Limitations.. 84Future Research.. 85

Conclusion.. 85

Appendix

A. Call for Participants 87B. Rules-based Scenario with No Incentive 89C. Principles-based Scenario with No Incentive. 105D. Rules-based Scenario with an Incentive. 122E. Principles-based Scenario with an Incentive.. 139F. Frequency Table and Bar Charts of Recommended Revenue by Case

Scenario157

REFERENCES.. 160

BIBLIOGRAPHY.. 165


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viii

LIST OF TABLES

Page

Table

1. Characteristics of Rules-based Standards and Principles-basedStandards..

23

2. Rules-based Accounting Framework.. 24

3. Sample Size.. 49

4. IMA e-mail blasts Compared to Responses Received (Sample)Demographics...

59

5. Summary Data on Participants. 62

6. Hypothesis 2 and Hypothesis 3: Analysis of Revenue-Recognition

Decision - Recommended Revenue.. 68

7. Hypothesis 1 and Hypothesis 4: Analysis of Revenue RecognitionDecision Y = (|Recommended Revenue Correct Amount|)/CorrectAmount

69

8. Hypothesis 1 and Hypothesis 4: Analysis of Revenue Recognition

Decision Y = (|Recommended Revenue $6 million|)/$6million... 70

9. Analysis of Revenue-Recognition Decision by Accounting Standard

Type and Incentive Conditions Sample Equals All ParticipantsAnswering Manipulation Check Question Correctly... 71

10.

Familiarity with Principles-based Standards and Judgment

Required 75


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ix

LIST OF FIGURES

Page

Figure

1.

Preference-Driven Versus Incentive-DrivenBehavior 45

2. Hypotheses - Accounting Standard Type Versus Incentive

Condition.. 49

3. Supported Hypotheses - Accounting Standard Type Versus Incentive

Condition . 76


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x

LIST OF GRAPHS

Page

Graph

1. Rules-based Recommended Revenue... 63

2. Principles-based Recommended Revenue 64


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11

CHAPTER I

INTRODUCTION

Support for adopting principles-based accounting standards (e.g., joint projects

currently being undertaken by the International Accounting Standards Board (IASB) and

Financial Accounting Standards Board (FASB)) has been gaining momentum (Financial

Accounting Standards Board, 2002a, 2002b; Pozen, 2007; Securities and Exchange

Commission, 2008). Approximately 120 nations and reporting jurisdictions permit or

require International Financial Reporting Standards (IFRS) for domestic-listed companies

(seewww.ifrs.com//ifrs_faqs.html#q3). In February, 2010, the Securities and Exchange

Commission (SEC) issued release numbers 33-9109 and 34-61578, Commission

Statement in Support of Convergence and Global Accounting Standards. The release

reiterated that the SEC continues to believe that a single set of high-quality globally

accepted accounting standards will benefit U.S. investors we continue to encourage the

convergence of U.S. GAAP (Generally Accepted Accounting Principles) and IFRS

(Securities and Exchange Commission, 2010b, p. 1). The SEC requested a Work Plan be

developed identifying areas to be considered prior to transitioning to a financial reporting

system incorporating IFRS. The release stated that the SEC would be in a position to

determine whether to incorporate IFRS in 2011 following the completion of the Work

Plan and completion of the FASB-IASB convergence projects. Several of the FASB-

IASB convergence projects have extended their project timelines into 2012. As a result,

in late 2011, the SEC postponed its decision on incorporating IFRS until 2012. If the SEC
http://www.ifrs.com/ifrs_faqs.html#q3http://www.ifrs.com/ifrs_faqs.html#q3


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does determine to incorporate IFRS into the U.S. reporting system, first time adoption

would occur approximately in 2015 or 2016 (Securities and Exchange Commission,

2010a).

U.S. accounting standards are perceived to be rules-based standards while IFRS

are thought to be principles-based standards (Benston, Bromwich, & Wagenhofer, 2006;

Financial Accounting Standards Board, 2002b; Schipper, 2003). Shifting from a rules-

based to a principles-based accounting framework will require more professional

judgment on the part of financial statement preparersjudgments and decisions in areas

involving accounting estimates, uncertainty, and inherent subjectivity. Further, the

standards will lack detailed guidelines, scope exceptions, and quantitative thresholds

(Bennett, Bradbury, & Prangnell, 2006; Benston, et al., 2006; Clor-Proell & Nelson,

2007; Financial Accounting Standards Board, 2002b). Little experimental research has

been performed on how the converged standards will affect the decisions made by

financial statement preparers.

Purpose of the Study

The purpose of this research is to examine whether the quality of financial

statements will be improved as a result of the anticipated convergence of United States

Generally Accepted Accounting Principles (U.S. GAAP) with IFRS as reflected in the

IASB-FASB Exposure Draft:Revenue from Contracts with Customers.The study

examines the financial statement preparers final revenue-recognition decision under a

principles-based accounting standard (the IASB-FASB Exposure Draft) compared to a


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rules-based accounting standard (U.S. GAAP) both with and without a personal incentive

to maximize revenue.

Background and Justification

Quality financial reports

Financial reports (i.e., financial statements and accompanying notes to the

financial statements) represent information about a companys economic resources,

claims against the company, and the effects of transactions and other events and

conditions that change these resources and claims. Statement of Financial Accounting

Concepts No. 8 (SFAC No. 8) Conceptual Framework for Financial Reportingprovides

the objective of general purpose financial reporting and the qualitative characteristics that

make financial reports better (more useful) for making decisions. Quality financial

reports help investors, creditors, and other users of the financial statements assess the

companys ability to generate net cash inflows and managements ability to protect and

enhance the capital providers investments. Usefulness for decision making is viewed as

the objective of general purpose financial reporting. As such, quality financial reports

provide information that is useful for decision making (Financial Accounting Standards

Board, 2010b).

The fundamental qualitative characteristics of useful financial information are

relevance and faithful representation. To be relevant, financial information is capable of

making a difference in the decisions made by users. Financial information is capable of

making a difference in decisions if it has predictive value, confirmatory value, or both


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(Financial Accounting Standards Board, 2010b, p. 17). Financial reports portraying a

flawless faithful representation of the financial information would illustrate three

characteristics: complete, neutral, and free from error. To be complete, all information

necessary for a user to understand the financial information reported must include all

necessary descriptions and explanations. A neutral depiction is without bias. That is, the

information presented is not skewed, influenced, emphasized or de-emphasized, or

manipulated such that the financial information shown will be received favorably or

unfavorably by users. Free from error means there are no material errors or omissions in

the description of the financial information and the process used to generate the reported

information has been selected and applied with no errors contained in the process

(Financial Accounting Standards Board, 2010b).

Enhancing qualitative characteristics are comparability, verifiability, timeliness,

and understandability. Usefulness is greatly enhanced if it can be compared with similar

information from other companies over the same or multiple periods of time. Related to

comparability is consistency. Consistency is present when a company applies the same

accounting treatment to similar events over a period of time or several periods.

Verifiability means that different knowledgeable and independent observers could reach

agreement. Timeliness means providing the information to decision-makers before it

loses its capacity to influence decisions. Lastly, understandability is the quality of

information that lets reasonably informed users comprehend its significance (Financial

Accounting Standards Board, 2010b).


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Revenue recognition

Revenue is generally the largest amount reported on the income statement.

Properly accounting for revenue has important implications for users (e.g., creditors,

investors, regulators) of financial statements. Revenue is a crucial number in assessing a

companys financialperformance and prospects(International Accounting Standards

Board, 2010a, p. 5). Prior to U.S. GAAP accounting standards codification (ASC), U.S.

GAAP revenue-recognition guidance comprised more than 200 pieces of guidance

(Financial Accounting Standards Board, 2008b) [e.g., Emerging Issue Task Force (EITF)

pronouncements, Statement of Positions (SOPs), Securities and Exchange Staff

Accounting Bulletins (SEC SABs)]. Many of the guidelines are industry-specific and

inconsistent across industries thus producing different results for economically similar

transactions. ASC did not change any of the requirements set forth by U.S. GAAP or the

Securities and Exchange Commission (SEC) nor did the industry specific guidance

change the inconsistencies. The inconsistencies continue to exist. The current IFRSs

underlying the two main revenue-recognition standards (International Accounting

Standard (IAS) 18Revenue and IAS 11 Construction Contracts) are inconsistent and

ambiguous (International Accounting Standards Board, 2008).

As a consequence of these conditions, the IASB and FASB are working together

on a joint revenue recognition project to clarify the principles for recognizing revenue.

The result would be that companies apply the guidance consistently across many

industries and transactions for both U.S. GAAP and IAS. In June 2010, the IASB and the

FASB released the Exposure Draft:Revenue from Contracts with Customers. The IASB

and FASB issued a second draft in late 2011 and are expected to release the final standard


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in 2012 or 2013. The Boards aspire to remove inconsistencies and weaknesses in the

current standards and practice, provide a more robust framework for addressing revenue-

recognition issues, simplify the preparation of financial statements by reducing the

number of standards to which companies refer, and improve comparability across

companies and geographical boundaries(International Accounting Standards Board,

2010b, p. 3). In addition the Boards stated the objective of this [draft] IFRS is to

establish the principles that an entity should apply to report useful information to users of

its financial statements about the amount, timing and uncertainty of revenue and cash

flows arising from a contract with a customer (p.17). Thus, it is apparent that the Boards

believe the draft standard is principles-based.

For many contracts with customers the proposed revenue-recognition model would

not impact the current revenue-recognition practice e.g., retail transactions, long-term

contracts in which revenue recognition already reflects the transfer of goods and services

to customers. However, in some situations applying the proposed revenue-recognition

model will differ from present practice.

Rules-based standards versus principles-based standards

U.S. GAAP are often regarded as rules-based standards while IFRS are

considered to be principles-based standards (Securities and Exchange Commission,

2003a). Concern in the U.S. with rules-based standards and appeals for a principles-based

approach to accounting standards emerged after the corporate accounting scandals in the

early 2000s (Financial Accounting Standards Board, 2002a, 2002b; Securities and

Exchange Commission, 2003a). Section 108 of the Sarbanes-Oxley Act of 2002


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instructed the Securities and Exchange Commission (SEC) to conduct a study on the

adoption of an accounting framework based on principles-based standards. FASB

(2002b) also responded by issuing a proposal summarizing the features of a principles-

based approach to standard setting. The following year, the SEC (2003a) published a staff

study supporting a principles-based standards (or objectives-oriented basis) approach to

standard setting.

The SEC staff study characterized the optimal principles-based accounting

standard as including a

concise statement of a substantive accounting principle where the accountingobjective has been incorporated as an integral part of the standard and where few,

if any, exceptions or internal inconsistencies are included in the standard. Further,

such a standard should provide an appropriate amount of implementation

guidance given the nature of the class of transactions or events and should bedevoid of bright-line tests. Finally, such a standard should be consistent with, and

derive from a coherent conceptual framework of financial reporting. (Securities

and Exchange Commission, 2003a)

The SEC staff study differentiated its view of a principles-based setting approach

from other principles-based approaches by reference to an objectives-oriented standard

setting approach. This approach provides the following:

In applying the objectives-oriented standard, financial statement preparers are

required to focus the accounting decisions on performing the accounting

objective of the standard

The standard is written in accordance with a unifying conceptual framework

The standard does not contain any exceptions or bright-line tests

The standard states the class of transactions to which they apply and contains

sufficient detailed guidance for preparers and auditors to determine the


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appropriate accounting for the companys transactions (Securities and

Exchange Commission, 2003a).

The SEC Staff Study referred to other views of principle-based standards as a

principles-only approach. A principles-only standard approach provides insufficient

guidance to make the standards reliably operational. As a result, principles -only

standards require preparers and auditors to exercise significant judgment in applying

overly-broad standards to more specific transactions and events, and often do not provide

a sufficient structure to frame the judgment that must be made (Securities and Exchange

Commission, 2003, p.6).

In contrast to principles-based standards are rules-based standards. Rules-based

standards are characterized as being very detailed and specific in applying the accounting

methods prescribed in the standard. Attributes of rules-based standards include

quantitative (bright-line) thresholds, examples, scope restrictions, treatment exceptions,

and detailed implementation guidance (Nelson, 2003; Nobes, 2005; Schipper, 2003).

In March, 2010, the SEC reaffirmed its strong commitment to a single set of

global accounting standards (Securities and Exchange Commission, 2010b). In addition,

the IASB and FASB are committed to convergence with the outcome being a shift from a

rules-based accounting system to a principles-based accounting system (objectives-

oriented) thus causing a significant change for U.S. GAAP accounting (Financial

Accounting Standards Board, 2002a). In a progress report following the February, 2006

Memorandum of Understanding, both Boards agreed that the goal of the jointprojects is

to produce common, principles-based standards, subject to the required due


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process(Financial Accounting Standards Board, 2008a). In their joint Conceptual

Framework project, the IASB and FASB Boards stated the objective of the project is to

develop an improved common conceptual framework that provides a sound

foundation for developing future accounting standards. Such a framework isessential to fulfilling the Boards goal of developing standards that are principles-based, internally consistent, and internationally converged and that lead to

financial reporting that provides the information capital providers need to make

decisions in their capacity as capital providers. The new framework, which willdeal with a wide range of issues, will build on the existing IASB and FASB

frameworks and consider developments subsequent to the issuance of those

frameworks (Financial Accounting Standards Board, 2010a).

An ongoing debate exists concerning whether comparability is improved under a

principles-based accounting framework. Critics of principles-based standards contend

that comparability is enhanced under rules-based standards as they are applying the same

detailed guidance (e.g., scope exceptions, bright-line tests). Thiscontention is disputed

by proponents of principles-based standards who believe the comparability to be

misleading as transactions can be manipulated to circumvent the rules-based standard

thus reducing transparency. Rigid, detailed standards may force unlike transactions into

the same accounting treatment or vice versa (Securities and Exchange Commission,

2003). The SEC (2003) considers comparability to be increased under a principles-based

approach to standard setting as the true economic substance of the transactions is

reflected.

Judgment, decision making, and incentives

Bonner (1999) refers to judgments as forming an idea, opinion, or estimate about

an object, event, a state, or another type of phenomenon (p.385). She defines the term

decision as making up ones mind about the issue at hand and taking a course of action


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(p. 385). Decisions usually follow judgments and imply a choice among alternative

outcomes based on judgments about those alternatives. Interpretation and application of

principles-based standards will require more judgment on the part of financial statement

preparers. Financial statement preparers will be required to form an opinion through their

evaluation of a principles-based accounting standard and ultimately make a decision on

how to report financial transactions.

Kunda (1990) states that individuals processing information may be influenced by

personal preferences and incentives and those motivations ultimately affect their

judgment process and decisions. Further, Boiney, Kennedy, and Nye (1997) found that

individuals will implement information processing strategies that will support their

particular motivated conclusion. The result is individuals information processing

decision will be decided in their favor. Normative theory indicates that decision makers

should use available information to make their most accurate judgment without being

influenced by incentives (Boiney, Kennedy, and Nye, 1997). Based on motivated

reasoning theory and normative theory, a judgment process void of incentives will lead

financial statement preparers to make more accurate judgments resulting in better

decisions and ultimately higher quality financial statements. The inherent flexibility in

the application of a principles-based standard may allow financial statement preparers to

report or manage earnings opportunistically.

Prior research

A modest amount of recent empirical research examining decisions made when

applying a principles-based standard compared to a rules-based standard exists. Segovia,


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Arnold, and Sutton (2009) examine what affect the type of expense standard has on the

auditors decision in allowing leeway in reporting practices and how the auditors

decision is influenced by the client and/or SEC pressure.

Two studies examine decisions made under rules-based and principles-based lease

accounting standards. Jamal and Tan (2010) examine the impact of the standard type on

financial managers (i.e., financial statement preparers) reporting judgments while

interacting with three different auditor types. Tsakumis, Doupnik, and Agoglia (2011)

examine the financial-reporting decisions of financial statement preparers, as well as the

role of the audit committee in mitigating aggressive reporting behavior.

Similarly, two studies examine consolidation standards in both a rules-based

standard and principles-based standard. Psaros and Trotman (2004) examined preparers

judgments to consolidate under the two standard types with and without incentives while

Psaros (2007) examined senior accountants judgments under the two standard types with

and without incentives.

As mentioned, on the income statement, revenue is typically the largest reported

line item. Yet, prior studies have been limited to a specific accounting topic (e.g., leases,

consolidations, impairment expenses) and empirical behavioral research has not

examined whether principles-based versus rules-based revenue-recognition standards will

differentially impact financial statement preparers decisions.

A recent experimental study by Clor-Proell and Nelson (2007) examined

example-based reasoning in the context of implementation guidance for accounting

standards. Participants were required to judge the appropriateness of income statement

recognition. In an archival study, Altamuro, Beatty and Weber (2005) use the reporting


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requirements imposed by SEC Staff Accounting Bulletin No. 101 to examine how

accounting methods that accelerate revenue recognition affect financial reporting.

Thus, this study focuses on the interactions of a principles-based standard versus a

rules-based standard with and without incentives to meet analysts forecasts. The

objective of this study is to experimentally investigate whether the standard type (rules-

based versus principles-based), with or without incentives will influence financial

statement preparers revenue-recognition decisions.

Summary

The FASB and IASB are committed to convergence with the likely outcome

being a shift from a rules-based accounting system to a principles-based accounting

system (Financial Accounting Standards Board, 2002a). It is unclear if this transition will

improve the decision-usefulness of the financial statements.

To date very few studies on the revenue-recognition differences between U.S.

GAAP and IFRS exist. Studies that have examined a principles-based standard compared

to a rules-based standard have generally focused on consolidations, leases, and expenses

accounting standards. This research provides initial evidence from an experimental

setting in determining the quality of revenue reported in the financial statements prepared

under both a rules-based standard and a principles-based standard using the objectives-

oriented approach proposed by the SEC Staff Study. This research examines financial

statement preparers decisions related to the revenue-recognition model contained in the

IASB-FASB Exposure Draft:Revenue from Contracts with Customers. Additionally, this

research builds upon prior research and provides important ex anteinformation of


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particular interest to practitioners setting entity strategy, regulators, and standard setters

in their finalization of a revenue-recognition model to be generally applied to various

industries, and investors as they evaluate the quality of the financial statements. The

research can aid in determining the factors that influence financial-statement preparers in

their decision-making process.

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