06-May-13

The Role Of Choice Within GAAP: Principles Or Rules?

Without accounting choice, there can be no experimentation, and without experimentation, best practices cannot develop. The importance of accounting choice in an unregulated setting has implications for the role of choice under regulated GAAP.

Regulator-determined principles and rules limit that choice to a subset of alternatives. The limits are based on regulators incentives and loss functions, and depend on their concerns over comparability, consistency, and reliability. These choices are subsequently limited by boards of directors, accountants, and auditors.

Detailed Working Rules For At Least Four Reasons.

It is not likely to be cost effective for accountants and auditors to work with principles on a day-to-day basis.

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If an audit opinion is challenged in court, auditors are better off citing a hard rule than an abstract principle that they have interpreted.

Even in non-litigious countries, auditor reputation can lead to the development of working rules from broader principles

On day-to-day issues, for efficiency reasons, users of financial statements will prefer accounting reports that are prepared under working rules

Eliminating such working rules under the desire for uniformity in an arbitrary conceptual framework is unlikely to result in a GAAP that can achieve its stated objective of efficient capital allocation.

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Summary Of Evidence On Market Efficiency

From the perspective of standard-setting, we argue the evidence of market inefficiency is much like waves over deep sea watersthe tranquility of deep waters underneath swamps any indication of turbulence from waves on the top. As such, it behooves us to assume market efficiency in deliberating accounting standards.

Why Should Market Efficiency Be The Maintained Assumption?

For the following reasons, we argue that developing standards on the premise of market inefficiency markets is unlikely to prove to be a useful model for standard setters.

1. Market inefficiency is not an equilibrium theory: There is

no behavioral theory to describe the relation of accounting information to stock market prices in an equilibrium of market inefficiency. Absent an equilibrium theory of market inefficiency, regulation that assumes inefficiency has no natural starting point.

Implications

2.Practical difficulties with the market inefficiency

assumption: As a practical matter, even if standard setters were to embrace inefficiency as the maintained assumption, we doubt market inefficiency has the potential to guide them in deciding on a suitable GAAP.

1. The debate over form versus substance in financial reporting

is unimportant for equity valuation, although it is relevant for efficient contracting.

2.If the analysis above is used to motivate accounting policy, the

debate will not be in the context of pricing and trading rules, but rather, standard setters will focus on substantive aspects of the form versus substance debate. The agency problems discussed earlier will be of first order importance to standard setters in designing GAAP.