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    Rules-Based Accounting Standards and Litigation
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats, 15.0 International Matters, 15.02 IFRS Changes – Impacts 
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    Title:
    Rules-Based Accounting Standards and Litigation
    Practical Implications:

    This study exploits variation in U.S. accounting standards to study the effect of rules-based standards on litigation. It provides evidence of an association between rules-based accounting standards and a lower incidence of securities class action litigation. This evidence informs the debate about switching from a more rules-based U.S. GAAP to a more principles based IFRS.


    For more information on this study, please contact John McInnis.
     

    Citation:

    Donelson, D., J. McInnis, and R. Mergenthaler. 2012. Rules-Based Accounting Standards and Litigation. The Accounting Review 87 (4): 1247-1279.

    Keywords:
    securities litigation, safe harbor, rules-based standards, principals-based standards
    Purpose of the Study:

    There is substantial debate about whether U.S. GAAP is too rules-based and should be scrapped for a more principles-based set of standards such as IFRS. Rules-based standards, which explicitly state bright-line thresholds and have detailed implementation guidance, are often criticized because they are said to shield firms from litigation. Critics argue that when firms do not clearly admit to an error by issuing a restatement they can rely on a “safe harbor” defense provided by rules-based standards. Since detailed standards require little managerial judgment and are objectively implemented prosecutors have difficulty calling managerial discretion into question thus creating a “safe harbor” within the rules. Furthermore, critics claim that even when firms admit to a misstatement by restating their financial statements, the complex nature of rules-based standards allows firms to avoid litigation due to the difficulty in ruling out the potential for unintentional mistakes (i.e. rules based standards provide a “innocent misstatement” defense).
        On the other hand, proponents of rules-based standards argue that they provide plaintiffs a “roadmap” to successful litigation. The specificity of rules-based guidance provides plaintiffs the ability to establish intent in situations where they clearly ignored specific guidance and were forced to restate as a result. This argument is essentially the opposite of the “innocent misstatement” argument.
    This study intends to provide evidence that is pertinent to this debate. The authors attempt to determine whether rules-based standards are associated with the incidence and outcomes of securities class action litigation.
     

    Design/Method/ Approach:


    The authors exploit variation in the extent to which some U.S. GAAP standards are more rules-based and some are more principles-based. They use data on resolved securities class action lawsuits filed from 1996-2005 that allege GAAP violations as well as restatement data from the same time period. They perform three analyses with this data:

    • Using a sample of lawsuits unrelated to restatements the authors test whether plaintiffs tend to allege violations of principles-based standards in order to leverage management’s more subjective implementation.
    • Using a sample of all restating firms, the authors test whether restatements are more likely to lead to litigation if they are related to rules-based statements in order to understand if rules-based standards actually provide a “roadmap” to successful litigation.
    • Using a sample of lawsuits the authors test whether meritorious lawsuit outcomes are associated with alleged violations rules-based standards.
       
    Findings:
    • The authors find that in cases where litigation is not connected to a restatement, plaintiffs allege violations of principles-based standards more often than violations of rules-based standards. This evidence is consistent with rules-based standards providing a “safe harbor” from litigation prompting them to be cited less often in litigation.
    • The authors find that when a restatement occurs, violations of rules-based standards are associated with a lower probability of litigation. This finding does not support the idea that rules-based standards provide a “roadmap” to successful litigation. Instead it is consistent with the “innocent misstatement” argument.
    • The authors find no relationship between rules-based standards and litigation outcomes.


    These findings are indicative of rules-based standards deterring litigation. However, the authors note that the overall effect of a shift to a more principles-based accounting system is difficult to predict due to numerous additional factors that would accompany this type of change.
     

    Category:
    Accountants' Reporting, International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, IFRS Changes – Impacts, Litigation Risk