Study: Rules-based Accounting Shields Firms From Lawsuits

According to groundbreaking research by Richard Mergenthaler, assistant professor of accounting at the University of Iowa Tippie College of Business, shareholders are more likely to sue firms that use principles-based accounting standards over rules-based standards.

The short:

Some claim that rules-based accounting standards shield firms from litigation, while others argue that violations of detailed rules give plaintiffs a “roadmap” to successful litigation. We inform this debate by investigating whether rules-based standards are associated with the incidence and outcome of securities class action litigation. Overall, our results suggest that rules-based standards are associated with a lower incidence of litigation but are not associated with litigation outcomes. These results are of interest in the debate regarding the switch from a more rules-based U.S. GAAP to a more principles-based IFRS.

So what this means is — believe it or not — principles-based accounting might leave firms more exposed when it comes to lawsuits. Interestingly, the study found no relation between rules-based standards and the suit outcome, even if the study found that rules-based accounting shields firms from lawsuits.

More amazing conclusions:

In his study, Mergenthaler’s team examined 353 class action securities lawsuits brought by investors against firms between 1996 and 2005. In 189 of those cases, firms restated earnings and acknowledged that a previous earnings statement was incorrect. In 164 of the suits, the firms did not restate earnings.

In those suits that do not involve restatements, the plaintiff tended to allege violations of principles-based standards because they had no specific evidence to allege a rules-based violation Mergenthaler says, suggesting rules shield firms from litigation.

In those suits that did involve earnings restatements, the study found violations of rules-based standards are associated with a lower probability of litigation.

Mergenthaler says these findings suggest the more rigorous rules-based procedures make it more difficult for shareholders to prove wrongdoing by the firm, making it less likely they’ll file a lawsuit. He says it’s difficult to demonstrate that managers intentionally misstated their financial statements when standards are complex. For instance, he says, the misstatement may simply be the result of an innocent mistake and not the result of malfeasance.

He says plaintiffs also find it harder to allege a specific violation of accounting procedures prior to the dismissal decision because they only have access to public information.

“This suggests rules-based standards decrease litigation risk by providing an ‘innocent misstatement’ defense for the restatements so they are not cited in lawsuits,” Mergenthaler says, noting that it’s easier for plaintiffs to second guess accounting decisions under the principles-based standards.

The study was published in The Accounting Review and if you're that interested, you can pony up the cash to read the whole thing.

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