FINANCIAL STATEMENT PREPARERS REVENUE DECISIONS: ACCURACY IN

APPLYING RULES-BASED STANDARDS AND THE IASB-FASB REVENUE

RECOGNITION MODEL
By
Mary McCarthy
A DISSERTATION

Submitted to the
H. Wayne Huizenga School of Business and Entrepreneurship
Nova Southeastern University

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in partial fulfillment of the requirements

for the degree of
DOCTOR OF BUSINESS ADMINISTRATION
2012

UMI Number: 3517281

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ABSTRACT
FINANCIAL STATEMENT PREPARERS REVENUE DECISIONS: ACCURACY IN
APPLYING RULES-BASED STANDARDS AND THE IASB-FASB REVENUE
RECOGNITION MODEL
by
Mary M. McCarthy

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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 revenuerecognition project is due to be finalized over the next year with the result being a shift
from a rules-based set of accounting standards to a principles-based standard. The
purpose of this research is to examine financial statement preparers software revenuerecognition decisions under a principles-based accounting standard compared to a rulesbased 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 rulesbased standards (U.S. GAAP) and a principles-based standard (IASB-FASB Exposure
Draft: 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 personal
incentive 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 amounts
were 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 applying
principles-based standards. The arithmetic means for rules-based subjects and principlesbased 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.

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 the
way ensured my pursuit for a doctoral degree was a success. In addition, I would like to
express 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 support
and encouragement over the past several years.

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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 the
time 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 express
my 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 committee
members, thank you.
Thank you to all my professors in the doctoral program. I thoroughly enjoyed the
program 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.

TABLE OF CONTENTS
Page
List of Tables..

viii

List of Figures.

ix

List of Graphs.

Chapter
11

Purpose of the Study and Research Questions..

Background and Justification
Summary.

12
13
24

REVIEW OF THE LITERATURE

24

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II.

INTRODUCTION..

I.

IV.

24

METHODOLOGY.

52

Experimental Instrument
Data Collection...........................
Experimental Procedures and Task
Research Design and Variables..

52
54
56
58

ANALYSIS AND PRESENTATION OF FINDINGS..

60

Introduction
Demographics.
Hypotheses and Statistical Analysis..........................
Familiarity with Standards.
Summary.

60
60
69
75
77

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III.

Pros and Cons of Principles-based and Rules-based

Standards
Judgment and Decision Making.
Prior Research Examining Principles-based Standards Versus Rulesbased Standards..
Revenue-Recognition Accounting Standards and Prior
Research..
Incentives-based and Motivation-based Theories..

vi

28
30
33
38

V.

SUMMARY AND CONCLUSION..........................

79

Research Findings..........................
Limitations..
Future Research..
Conclusion..

79
84
85
85

Appendix
Call for Participants
Rules-based Scenario with No Incentive
Principles-based Scenario with No Incentive.
Rules-based Scenario with an Incentive.
Principles-based Scenario with an Incentive..
Frequency Table and Bar Charts of Recommended Revenue by Case
Scenario

A.
B.
C.
D.
E.
F.

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REFERENCES..

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BIBLIOGRAPHY..

vii

87
89
105
122
139
157

160
165

LIST OF TABLES
Page
Table
Characteristics of Rules-based Standards and Principles-based
Standards..

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.

6.

Hypothesis 2 and Hypothesis 3: Analysis of Revenue-Recognition

Decision - Recommended Revenue..

8.

9.

10.

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7.

1.

Hypothesis 1 and Hypothesis 4: Analysis of Revenue Recognition

Decision Y = (|Recommended Revenue Correct Amount|)/Correct
Amount

62

68

69

Hypothesis 1 and Hypothesis 4: Analysis of Revenue Recognition

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

70

Analysis of Revenue-Recognition Decision by Accounting Standard

Type and Incentive Conditions Sample Equals All Participants
Answering Manipulation Check Question Correctly...

71

Familiarity with Principles-based Standards and Judgment

Required

75

viii

LIST OF FIGURES
Page

Hypotheses - Accounting Standard Type Versus Incentive

Condition..

49

Supported Hypotheses - Accounting Standard Type Versus Incentive

Condition .

76

3.

45

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2.

Preference-Driven Versus Incentive-Driven

Behavior

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Figure
1.

ix

LIST OF GRAPHS
Page
Graph
Rules-based Recommended Revenue...

63

2.

Principles-based Recommended Revenue

64

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1.

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

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

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

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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 FASBIASB 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

12
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 rulesbased to a principles-based accounting framework will require more professional
judgment on the part of financial statement preparers judgments and decisions in areas

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

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standards will lack detailed guidelines, scope exceptions, and quantitative thresholds
(Bennett, Bradbury, & Prangnell, 2006; Benston, et al., 2006; Clor-Proell & Nelson,

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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

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conditions that change these resources and claims. Statement of Financial Accounting
Concepts No. 8 (SFAC No. 8) Conceptual Framework for Financial Reporting provides

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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

14
(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

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information has been selected and applied with no errors contained in the process
(Financial Accounting Standards Board, 2010b).

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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).

15
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 financial performance 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

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Accounting Bulletins (SEC SABs)]. Many of the guidelines are industry-specific and
inconsistent across industries thus producing different results for economically similar

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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) 18 Revenue 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

16
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 revenuerecognition 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

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believe the draft standard is principles-based.

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

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

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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

17
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 principlesbased 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

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concise statement of a substantive accounting principle where the accounting

objective 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 be
devoid 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

18
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).

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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

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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 (objectivesoriented) 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 joint projects is
to produce common, principles-based standards, subject to the required due

19
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 is
essential to fulfilling the Boards goal of developing standards that are principlesbased, 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 will
deal 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

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that comparability is enhanced under rules-based standards as they are applying the same
detailed guidance (e.g., scope exceptions, bright-line tests). This contention is disputed

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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

20
(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

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individuals will implement information processing strategies that will support their
particular motivated conclusion. The result is individuals information processing

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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,

21
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.

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

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

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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

22
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 (rulesbased versus principles-based), with or without incentives will influence financial
statement preparers revenue-recognition decisions.

Summary

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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

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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 objectivesoriented 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 ante information of

23
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

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their decision-making process.