We Knew it All Along: Rules Based = Protection

GAAP's Lawsuit Buffer

The rules-based nature of U.S. generally accepted accounting principles may actually discourage shareholder lawsuits, says a new study

The debate over whether principles-based accounting standards are better than rules-based standards has divided many accountants, and stymied regulators who want to move U.S. accounting toward less-prescriptive guidance.

One argument against that nearly decade-long push has been that moving away from bright lines and layers upon layers of rules (as is characteristic of U.S. generally accepted accounting principles) would lead to more class-action lawsuits from shareholders second-guessing companies' accounting decisions. Because standards more reliant on principles (such as international financial reporting standards, or IFRS) give users more room to make judgment calls, observers worry that adopting such standards will open companies up to more Monday-morning quarterbacking by auditors, regulators, and the plaintiffs' bar.

Indeed, it's long been assumed that adopting principles-based standards would raise companies' litigation risk. For instance, in a 2003 report encouraging a move toward more "objectives-oriented rules," the Securities and Exchange Commission said a new system would carry with it "litigation uncertainty." At the time, the commission argued that litigation exposure could be minimized by companies and their auditors properly documenting the reasoning behind their judgment calls under a principles-based system.

Now, three university professors have gathered empirical evidence suggesting that litigation is indeed an issue in the principles-versus-rules discussion. Their study, "Rules-Based Accounting Standards and Litigation," suggests that companies that violate rules-based standards have a lower likelihood of getting sued than those that are accused of violating more-principles-based standards.

The professors looked at securities class-action suits alleging GAAP violations filed between 1996 and 2005, as well as 84 restatements made during that same time frame that did not result in litigation. Rather than judge GAAP as a whole as a rules-based system, they considered the prescriptiveness of the standards mentioned in each case, based on four characteristics: level of bright-line thresholds, exceptions, implementation guidance, and detail.

The standards were measured on a "rules-based continuum" scale running from zero to four, with zero denoting the most principles-based standards and four indicating the most rules-based standards. Accordingly, the standard for contingent liabilities, which requires judgment calls, scored zero, while accounting for leases scored four.

However, the professors shied away from concluding whether the adoption of more-principles-based standards as a whole in the United States would invite more lawsuits for American companies. The unique litigation system of this country, as well as the more litigious nature of the society, makes it difficult to directly compare the U.S. system with that of Europe or beyond, they say.

Still, over time, IFRS could become more rules-based if demands for carve-outs and additional guidance continue as they have in the United States, says study co-author John McInnis, an assistant professor at the University of Texas at Austin. "Even if we adopt a more principles-based system, I'm not sure it would stay that way," he says. Rather, the professors believe their study provides a building block for U.S. regulators and other researchers to consider as the merits of adopting IFRS continue to be weighed. (The SEC plans to decide next year whether to require U.S. companies to make a switch to the global rules, starting in 2015.)

For now, apparently, GAAP and its inherent complexity give U.S. companies a defense against lawsuits by allowing them to "shield themselves behind the rules," says McInnis. "If you follow the rules, it appears that you are protected."

Shareholders have the burden of proving that a GAAP violation was intentional, not an easy task when many layers of rules provide many opportunities for mistakes. "We find that firms are less likely to be sued when they violate standards that are more rules-based, consistent with the view that the complexity of rules-based standards provides a credible 'innocent misstatement' presumption," the professors wrote.

The professors acknowledge several limitations of their research. Among them is the fact that it's not possible to observe initial shareholder claims that lawyers drop before submitting them into the court system. Also unanswerable is whether a more principles-based system would lead to fewer restatements, which often trigger shareholder lawsuits in the United States if they affect the stock price.

article by Sarah Johnson at CFO.com