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Effects of the Type of Accounting Standards and Motivation on Financial

Reporting Decision. Journal of Accounting Business and Management (Vol.18,
no.2)

Article · January 2011

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 Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 84-104

Effects of the Type of Accounting Standards and Motivation

on Financial Reporting Decision
Gerui (Grace) Kang*
Jerry W. Lin†

Abstract

This study explores whether the precision (type) of accounting standards

influences management accounting reporting behaviors when an environmental
variable, motivation, is incorporated. We predict that motivation affects management’s
financial reporting decision. When management has motivations to make aggressive
reporting, they are more likely to do so than if they do not have such motivation.
Furthermore, we posit that the type of accounting standard interacts with motivation
and affects management’s accounting decision. When management has motivation to
report aggressively, with rules-based accounting standards, management is more likely
to be guided by the precise numerical thresholds to achieve aggressive reporting than
with principles-based accounting standards. We conduct a 2x2 between-subjects
experiment. Ninety-six senior accounting students participate in this study. The
results support our predictions that when management has motivation for aggressive
reporting, they will make motivation-consistent accounting choice. Furthermore,
under rules-based accounting standards, management is more likely to choose
aggressive reporting than under principles-based accounting standards, when
management has motivations to do so.

Keywords: Principles- versus Rules-based accounting, motivation, motivated

reasoning theory, lease, aggressive reporting, U.S. GAAP versus IFRS.

I. INTRODUCTION

The recent well-publicized accounting scandals such as Enron and WorldCom

have led to criticisms that the current U.S. accounting standards may be partially
responsible for the occurrence of these scandals. One of the major criticisms of the
current U.S. accounting standards is that they are more rules-based than principles-
based and provide so many detailed directions (i.e., “bright lines”) that managers may
follow to achieve their favorite accounting treatment. Furthermore, it is difficult for
auditors to challenge management’s accounting choice when detailed rules serve as

* University of Minnesota
Duluth, MN 55812
Office: 218-726-6988 Fax: 218-726-8510
Email: gkang@d.umn.edu
† Colorado State University
Pueblo, CO 81001
Phone: 719-549-2105 Fax: 719-549-2909
Email: jerrywlin@gmail.com
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 85

management’s justification (e.g., Maines et al., 2003). Nelson et al. (2002) find that
auditors responding to their survey usually are reluctant to argue “substance over
form” when the clients clearly comply with precise accounting criteria. Therefore,
many accounting researchers believe that it is time to reform the current U.S. GAAP
and make it more principles-based. They suggest that principles-based accounting
standards may mitigate aggressive financial reporting. Some studies find that the
quality of accounting information improves under principles-based accounting
standards presumably by constraining management’s aggressive reporting behavior
(e.g., Barth et al., 2008; Jamal and Tan, 2010; Tsakumis et al., 2009; Webster and
Thornton, 2005). However, other studies (e.g., Cuccia et al., 1995; Nelson et al., 2002)
find that switching from rules-based to principles-based accounting does not
necessarily reduce aggressive reporting.
The inconsistent results in the prior studies motivate this study. Furthermore,
based on a review of relevant literature, Nelson (2003) concludes that, regardless of
the precision of accounting standards, management may consciously or unconsciously
choose financial reporting consistent with their incentives. Nelson (2003) suggests that
if accounting standard setters or regulators desire conservative (or less aggressive)
reporting, they should set accounting standards that are imprecise enough to avoid
precise “safe harbors” so as to prevent or minimize incentive-consistent interpretation
to take place. The current efforts by the FASB and the SEC to reform U.S. GAAP to
make it more principles-based have serious implications for all the stakeholders
concerned about the quality of financial reports. Given the significant consequences
and costs of such accounting reform, it is important to examine whether switching
from a rules-based to a principles- based accounting really mitigates aggressive
reporting and thus improves the quality of accounting information. Using accounting
for leases by the lessee, we examine whether rules-based accounting is more likely to
result in aggressive financial reporting than principles-based accounting. Also, we
investigate whether there are some factors, such as motivation, that may accentuate or
mitigate aggressive financial reporting under the two sets of accounting standards. In
this study, we manipulate the type of accounting standards and apply the motivated
reasoning theory to address these research questions.
Many behavioral studies suggest that people themselves are the number one
factor that influences their judgment and decision making (Bonner, 2008; Libby and
Lipe, 1999). Generally, motivation is thought to impact people’s judgment and
decision (Bonner, 2008). For example, Cuccia et al. (1995) find that motivation
influences tax practitioner’s tax reporting decision. Nelson et al. (2002) find that,
based on a survey of auditors, when managers of their clients have motivations to
prepare aggressive reports, they would consciously (or unconsciously) attempt to
make financial reports consistent with their incentives no matter what type of
accounting standard they have to follow. Maines et al. (2003) also suggest that
motivation plays a crucial role in management’s financial reporting decision.
Therefore, we suggest that that when management has motivation or pressure strong
enough to make aggressive reporting, they will find some ways to meet the
requirements of accounting standards and achieve their desired accounting goals. We
posit that when management have motivation to make aggressive reporting, they are
more likely to do so than if they do not have motivation to engage in aggressive
reporting, regardless of the precision or nature of the accounting standards.
Furthermore, Psyzcnski and Greenberg (1987) argue that if people have a clear
target or goal, they would be motivated to achieve this goal. The clearer the goal is, the
86 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

stronger the motivation they have to achieve the goal. As long as people can construct
a seemingly reasonable (or objective) justification to convince themselves and others,
they would believe that their choice is the best or most logical. This is the core of
motivated reasoning theory. Motivated reasoning theory describes how individuals
process information to support their desired judgment and decision while maintaining
the illusion of objectivity (Kunda 1990; Psyzcnski and Greenberg 1987). For example,
whether management makes an aggressive reporting depends on whether they have
the motivation and whether they are able to construct a reasonable justification to
convince those involved in the financial reporting process, such as the independent
auditors. Therefore, having a motivation and being able to construct a seemingly
reasonable justification are the two necessary and sufficient conditions for
management to make aggressive reporting.
When management has motivation to report aggressively, applying rules-based
accounting makes it easier for management to construct a seemingly reasonable or
objective justification than applying principles-based accounting. Therefore, the
likelihood for them to make aggressive reporting increases under rules-based than
under principles-based accounting. For example, “bright lines” or numerical
thresholds such as 75% of useful life and 90% of fair market value inherent in the
current U.S. lease accounting standard would direct management to achieve their
desired accounting treatments by aggressively managing reported accounting numbers
to meet such precise thresholds without being challenged by auditors. However, the
current international lease accounting standard with only vague thresholds (i.e., “major
part”) would make it more difficult for management to construct a reasonable
justification. Management and auditors may interpret the vague thresholds differently.
Management has to justify that their interpretation is more appropriate. Since no clear
“target” is available to the management, the difficulty for them to hit the “target”
increases. Also, the difficulty for management to construct a reasonable justification
increases as well. Therefore, we predict that motivation and precision of accounting
standards jointly influence management’s reporting behavior. When management has
motivation to report aggressively, the likelihood for them to do so is higher when
applying rules-based accounting standards than when applying principles-based ones.
We choose accounting for leases by the lessees as the experimental standard. In
particular, we choose the U.S. lease accounting standard (SFAS No. 13) as the proxy
for rules-based accounting standard and the International Accounting Standards (IAS)
lease accounting standard (IAS 17) as the proxy for principles-based accounting
standard. These two accounting standards are commonly used in prior studies as
examples for rules-based versus principles-based accounting (e.g., Jamal and Tan,
2010). In the experiment, we ask subjects to make their accounting choice under
either SFAS No.13 or IAS 17 and either with or without motivation for making an
aggressive reporting decision. Evidence of prior research suggests that most lessee
firms prefer operating leases to capital leases (e.g., Bowman, 1980; Imhoff and
Thomas, 1988; Reither, 1998) because of the negative effect on financial statements of
capital leases vis-à-vis operating leases. Thus, choosing operating leases stands for
making an aggressive reporting decision. This study tests how bright lines (or the lack
of) in the lease accounting standards may cause aggressive reporting when motivation
exists or does not exist.
We conduct a 2x2 between-subjects experiment. Motivation and the type of
accounting standard are the two between-subjects variables. Participants are randomly
assigned to one of the four groups. We find that when management has motivation
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 87

to make aggressive reporting choice (i.e., by accounting for the lease as an operating
lease), it is more likely for them to do so under a rules-based accounting standard (i.e.,
SFAS 13) than under a principles-based accounting standard (i.e., IAS 17). Our
findings indicate that the precision of accounting standards causes aggressive
reporting choice by management, especially when management has motivation to do
so. Thus, making the current U.S. accounting standards more principles-based may
help mitigate aggressive reporting, as suggested by Nelson (2003) and argued by
supporters of principles-based accounting.
This study makes a number of contributions to the literature and the continuing
debates about the merits of rules-based versus principles-based accounting standards.
First, the findings may be of interest to the U.S accounting standard setters and
regulators. The FASB has been working with the IASB to converge the current U.S.
GAAP with international financial reporting standards (IFRS) to make U.S. GAAP
more principles-based. The SEC has recently allowed foreign issuers to use IFRS
without reconciliation with U.S. GAAP. And, the SEC has also set a time-line for
conversion to IFRS by U.S. firms. Our findings suggest that this movement and
transformation is meaningful. Second, it may be necessary to further strengthen
current mechanisms (e.g., corporate governance structure) in financial reporting
oversight to control the influence of motivation on aggressive reporting by
management. Motivation is an environmental variable that exists in every accounting
situation and its effects are pervasive. It would not be possible to eliminate the
potential negative effect of motivation on financial reporting quality. However, if
accounting regulator and companies could use corporate governance and other
mechanisms to control management’s motivation, aggressive reporting may be
mitigated substantially. Third, although the likelihood of aggressive reporting is lower
under a principles-based accounting than under a rules-based accounting, having a
principles-based accounting cannot completely eliminate aggressive reporting in the
presence of managerial motivation to do so. Therefore, it is still important for a
company to have a strong system of financial reporting oversight such as an effective
corporate governance system. Furthermore, vigorous enforcement activity may be
necessary to shift motivations away from aggressive reporting and toward
conservative reporting as Nelson (2003) suggests. Lastly, our study is the first study to
apply motivated reasoning theory to explore how motivation and precision of
accounting standards jointly influence management’s financial reporting choice. While
motivated reasoning theory has been applied in prior accounting studies to explore
how accounting professional’s decision making is biased towards their desired
conclusions (e.g., Kachelmeier and Messier 1990, Hackenbrack and Nelson 1996,
Kadous and Peecher 2003), all these studies applied it in the auditing context. We
extend its application to management’s financial reporting behavior.
The remainder of this paper is organized as follows. Section II explains the
underlying theories, reviews selected prior literature and develops the research
hypotheses. Section III describes the experimental design, materials and method.
Section IV discusses the results. The last section provides a summary and concludes
the paper.

II. THEORIES PRIOR LITERATURE AND HYPOTHESES

The evidence in psychological literature suggests that motivation plays an

important role in the change of management’s behavior (Libby and Lipe, 1992).
88 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

Motivation can be defined as an intermediate state of an organization that drives it to

action (Reber, 1995; Bonner, 2008). Motivation is thought to influence judgment and
decision making quality. People can be motivated to reach a judgment or conclusion
they desire (Kunda, 1990).
The evidence in accounting literature also suggests that motivation is one of the
environmental variables that affect human’s cognitive efforts and influence their
judgment and decision (Ashton, 1990; Bonner, 2008). Libby et al. (2002) note that
monetary incentive, a form of motivation, influences accounting practitioners’
behavior in decision making. Cuccia et al. (1995) find that motivation influences tax
decision through interpretations of vague tax standard or through structuring
transaction under a more stringent standard. Nelson et al. (2002) find that when
managers have motivations to prepare aggressive reports, more detailed, more
quantitative and more stringent standards cannot reduce the aggressiveness of
reporting. Maines et al. (2003) summarize prior research and conclude that bright lines
or flexible nature of the governing accounting standard is important, but
motivation/incentives of managers are important as well. Psaros and Trotman (2004)
find that incentives impact accountants’ consolidation judgment. Specifically, they find
that accountants with incentives are more likely to process accounting information
aggressively. Based on these prior studies’ findings, we conclude that when
management has motivation/pressure to engage in aggressive reporting, they would
exert more effort to achieve their goals. Our first hypothesis is as follows:

H1: Management with motivation to report aggressively is more likely to choose aggressive reporting
than management without motivation.

The earlier behavioral studies in accounting suggest that principles-based

accounting cannot mitigate aggressive reporting. Nelson (2003) reviews prior studies
(most in the context of auditing) and states that aggressiveness of reporting decisions
increases with the imprecision of the relevant standards. For example, Nelson et al.
(2002) survey 252 auditors and find that management attempt to engage in earning
management by structuring transactions under precise accounting standards, and by
exploiting the latitude inherent in the vague language used in imprecise accounting
standards. Cuccia et al. (1995) conduct two experiments in a tax setting to test the
influence of numerical versus verbal thresholds on aggressive reporting. They find that
tax practitioners are equally likely to make aggressive reporting under either precise or
imprecise tax regulations. Overall, these earlier experimental studies suggest that the
aggressiveness of reporting behavior increases with the imprecision of the relevant
standards. However, as Nelson (2003) points out, it is premature to conclude that
reporting behavior is always more aggressive under imprecise standards because these
studies are conducted in settings where incentives tend to favor aggressive reporting.
In contrast, more recent empirical and behavioral studies suggest that principles-
based accounting may mitigate aggressive reporting. Webster and Thornton (2005)
find that Canada’s relatively principles-based GAAP actually yield higher accounting
quality than the U.S.’ relatively rules-based GAAP. Barth et al. (2008) conduct an
empirical study across 21 countries and find that the application of International
Accounting Standards (more Principle-based than the U.S GAAP) is associated with
higher accounting quality (less earning management). The findings of the more recent
behavioral studies suggest that principles-based accounting may mitigate aggressive
reporting (e.g. Psaros and Trotman 2004; Jamal and Tan 2010; Tsakumis et al., 2009).
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 89

For example, Jamal and Tan (2010) conduct an experiment to investigate how auditor
characteristics and the type of accounting standards jointly influence financial officers’
financial reporting judgments. They find that a move towards more principles-based
accounting is likely to result in improved financial reporting quality when there is a
corresponding shift in auditors’ mindsets towards being more principles-oriented.
Tsakumis et al. (2009) explore how the precision of accounting standards and audit
committee strength jointly influence financial reporting decisions. They find that
accounting preparers are less likely to make aggressive reporting under more
principles-based accounting than under more rules-based accounting with the
presence of a strong audit committee.
The inconsistent findings between the earlier studies and the more recent studies
may be due to a number of factors. As mentioned above, while the earlier studies find
financial reporting to be more aggressive under imprecise standards, these studies are
conducted in settings where incentives tend to favor aggressive reporting (Nelson,
2003). Furthermore, these earlier studies did not consider the influence of
environmental variables (e.g., motivation, the characteristics of auditor committee,
etc.) on reporting behavior. These variables may jointly with the type of accounting
standards influence management’s reporting decisions. The more recent studies
investigate the joint influence of the characteristics of corporate governance and the
type of accounting standards. However, no study has investigated the interactive effect
of motivation and the precision of accounting standards on aggressiveness of
management’s reporting decisions. We attempt to explore this joint effect in this
study. We apply motivated reasoning theory to explain how motivation may interact
with the precision of accounting standards and then influence management’s decision
in accounting report.
Motivated reasoning theory suggests that individuals’ motivations affect their
processes of reasoning. Individuals tend to seek, construct and evaluate evidence
consistent with their desired conclusions. Therefore, individuals are more likely to
arrive at conclusions they desired. However, whether individuals can do so depends
on if they can construct a seemingly reasonable justification for these conclusions,
because individuals attempt to be rational and then to persuade others. This is called
that people maintain an “illusion of objectivity” (Kunda, 1990). In short, whether
individuals believe in something depends on whether they want to believe and whether
they are able to construct a seemingly reasonable justification. For example, whether the
management of a company chooses aggressive reporting depends on whether they
have the motivation and whether they are able to construct a reasonable justification
to convince the auditors. Therefore, having a motivation and being able to construct a
seemingly reasonable justification are the two necessary and sufficient conditions for
management to make aggressive reporting. Next, we discuss why and how the
precision of accounting standards influence management’s ability to construct a
reasonable justification and then influence their ability to make aggressive reporting.
Kunda (1990) suggests that there are two major categories of the motivated
reasoning phenomena: (1) individuals are motivated to arrive at an accurate conclusion
(accuracy goal), and (2) individuals are motivated to arrive at a particular, directional
conclusion (directional goal). A directional goal provides people with a fussy
direction. In contrast, an accuracy goal shows people a clear target. It clearly presents
people with the path leading to this goal. People may structure information and
evidence exactly leading to the specific goal. In the presence of accuracy goals, self-
90 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

serving bias will be amplified and the reasoning will be worse than in the presence of
directional goals (Kunda, 1990; Pyszczynski and Greenberg, 1987).
The rules-based accounting standards characterized by “bright lines” and
“numerical thresholds” have provided lots of such clear “targets” to management.
These targets, like accuracy goals, clearly “tell” management what they need to do to
hit them. When management has successfully “hit” the targets by structuring
transactions, they can choose their favorite accounting treatments without being
challenged by auditors. For example, under U.S. lease accounting standard, two bright
lines are provided to the management: 75% of economic life and 90% of fair value
tests. If a lease does not include title transfer or a bargain purchase option but the
management of the lessee wants to treat this lease as an operating lease, they simply
make the lease not pass the 75% and 90% tests. Here, 75% and 90% are two accuracy
goals to management. As long as they do not hit them, it would be easy for them to
“convince” the auditors their decision is “reasonable.” Therefore, under rules-based
accounting, the possibility for management to construct a reasonable justification to
support their favorite accounting treatment is high.
Under a principles-based accounting system, there are no bright lines provided to
the management. No accuracy goals direct managers to manage reported results. The
difficulty for them to make a reasonable justification supporting their favorite
accounting treatment is greater than if they are provided with bight lines. For example,
under the International Accounting Standards, no bright lines exist in the lease
accounting. “Majority” is used to replace 75% and 90%. If a lease contract does not
include title transfer or a bargain purchase option while the management of the lessee
wants to treat a lease as an operating lease, they have to carefully interpret the
meaning of “majority.” Here, “majority” is like a directional goal; it is fuzzy. Auditors
may interpret “majority” as 51% while the management may interpret “majority” as
60%. Management has to convince the auditor their interpretation is better than that
of the auditors, given the nature of the lease. It would be much more difficult for the
management to construct a reasonable justification to convince the auditors that their
favorite accounting treatment is more appropriate.
In summary, when management has the motivation to make aggressive reporting,
they would use the “bright lines” inherent in rules-based accounting for them to more
easily construct a reasonable justification to convince the auditors to accept their
choice. Therefore, when management has motivation to choose aggressive reporting,
it is more likely for them to do so under a precise accounting standard with bright
lines and numerical thresholds than under an imprecise standard with only verbal
thresholds. Hence, we generate the following hypothesis:

H2: Management with motivation to make aggressive reporting decisions is more likely to do so when
there are precise numerical thresholds than when there are only verbal thresholds in an
accounting standard.

III. EXPERIMENTAL DESIGN

The Current U.S .GAAP versus IAS

Many accounting practitioners and researchers believe that U.S. GAAP provides
an example of rules-based accounting, which is characterized by bright lines, multiple
exceptions and a high-level of detailed guidance (SEC, 2002). Principles-based
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 91

accounting stresses the objective of accounting standards and the importance of

professional judgment and bright lines are avoided. Many accounting scholars and
practitioners point to International Accounting Standards (IAS) as an example of
principles-based accounting (SEC, 2002; Jamal and Tan, 2010). So, in this study, we
will use an accounting standard with many numerical thresholds (bright lines) under
U.S. GAAP as the proxy of rules-based accounting and an accounting standard with
verbal thresholds only under IAS as the proxy of principles-based accounting.

Lease Accounting

The standard for lease accounting for the lessees under the U.S. GAAP (SFAS
No.13) has been thought to be the worst accounting standard (Reither, 1998). In 1996,
AAA/FASB Financial Reporting Issues Conference conducted a survey in which the
participants of the conference were asked to complete a survey of what they thought
were the best and worst accounting standards. The results show that SFAS No.13 is
identified as the worst accounting standard (Reither, 1998). The major reasons are this
standard (1) fails to achieve reporting objectives for long-term leases because many
obligations that are, in substance, capital, sales-type, or direct-financing leases are
recognized as operating leases, (2) has too many bright lines for lease capitalization
resulting in abuse of standard, (3) is too complicated: many amendments,
interpretations and EITF issues, and (4) relies too heavily on disclosure to assess lease
obligations (Reither, 1998, p.288). Therefore, we select lease accounting standard for
the lessees as the experimental standard.
Under SFAS No. 13, when at least one of the four criteria is present at the
inception of a lease, the lease is classified as a capital lease by the lessee. Of the four
criteria, two are numerical thresholds (the lease term covering 75% or more of useful
life and the present value of minimum lease payments being 90% or greater of the fair
market value). Under IAS 17, when one or more of the four criteria is present at the
inception of a lease, the lease is classified as a capital lease by the lessee. There are
verbal (i.e., “major part” replacing 75% and 90%) but no numerical criteria in IAS 17.
In this study, we ask subjects to make a lease classification based on one of the four
criteria, the threshold about the lease term under SFAS No.13 or IAS 17.

Subjects

A total of 96 senior accounting students from a mid-size public university

participate in this study. All the subjects have taken Intermediate Financial Accounting
II. They act as the in-charge accountant making the lease reporting decision. Prior
studies find that students are adequate surrogates for accounting practitioners in
accounting judgment and decision making (e.g., Ashton and Kramer, 1980;
Liyanarachi and Milne, 2005). For example, Ashton and Kramer (1980) replicate
Ashton’s (1973) study by using students as surrogates for auditors to make internal
control judgments. By comparing the results of the two studies, Ashton and Kramer
(1980) find that no significant difference exists and experience does not make a
significant difference in the results. They conclude that students are adequate
surrogates for the auditors. Liyanarachi and Milne (2005) conduct an empirical study
testing the use of students as surrogates for accounting professionals. They find that
students can be adequate surrogates for practitioners in decision making tasks. Based
92 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

on the findings of these prior studies, we believe that it is appropriate for us to have
senior accounting students participate in our study.
In this study, we conduct a 2x2 between-subjects experiment: (1) “With
motivation” vs. “Without motivation” and (2) “Rules-based Accounting/Numerical
thresholds – SFAS 13” vs. Principles-based Accounting/Verbal thresholds – IAS 17.”
Subjects are randomly assigned to one of the four groups: (1) “With motivation” and
“Under SFAS No.13,” (2) “With motivation” and “Under IAS 17,” (3) “Without
motivation” and “Under SFAS No.13,” and (4) “Without motivation” and “Under
IAS 17.”

Independent Variables Manipulation

We manipulate two independent variables: motivations and type of accounting

standards. Management’s motivations to make an aggressive or a conservative
reporting decision are manipulated by using different descriptions about the
experimental company. The experimental company, Paine Company, is a lessee that
leases computer equipments from another company.
We use the following statement to manipulate the factor of motivation under the
“With Motivation” condition:

“Your boss, the controller of Paine Company is a risk-taker. Your boss tells you
that Paine has a significantly higher debt to equity ratio and a lower return
on asset ratio than the industry averages. Your boss expects you to exploit
any possible opportunities to boost return on asset ratio and decrease debt to equity
ratio.”

When the managers believe that taking risk and choosing an aggressive
accounting treatment make good business sense, they may have motivations to make
an aggressive reporting decision.
Under the “Without Motivation” condition, we used different statement to
describe the business of the lessee, Paine Company:

“Your boss, the controller of Paine Company is risk-averse. Your boss tells you that
Paine has a significantly lower debt to equity ratio and a higher return on
asset ratio than the industry averages.”

When the managers believe that avoiding risk and choosing a conservative
accounting treatment make good business sense, they may not have motivations to
make an aggressive reporting decision.
In this study, we use SFAS No.13 and IAS No.17 as the proxies for rules-based
and principles-based accounting standards, respectively. Under SFAS No. 13 and IAS
No. 17, when one or more of the following four tests -- Transfer of ownership test,
Bargain purchase option test, Economic life test, and Recovery of investment test -- is
passed at the inception of a lease, the lease should be classified as a capital lease by the
lessee. In this study, we assume that all the other three tests are not passed. Subjects
have to make their accounting choice based on only one test: economic life test.
Under SFAS No.13, if the lease term, at inception, is 75% or more of the estimated
economic life of the leased property, this test is passed, the subject have to treat this
lease as a capital lease; Under IAS 17, if the lease term is for the major part of the
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 93

economic life of the leased asset, this test is passed, the subjects have to classify this
lease as a capital lease. We state the lease terms (in years) but we do not specify the
economic life of the leased property in this study. Instead, we just provide the subjects
with a range of the estimated useful life of the leased property. Subjects need to
exercise their judgment to determine the economic life of the leased property.

Dependent Variable Manipulation

The dependent variable of this experiment is the choice of lease accounting. We

ask subjects to decide whether they treat this lease as a capital lease (conservative
position) or an operating lease (aggressive position). Most of prior research suggests
that firms prefer operating leases to capital leases. The basic reason is that at inception
capital leases increase a firm’s debt to equity ratio and decrease its return on assets
ratio, and that affects negatively investors’ perception of the firm’s risk and
performance. In comparison, operating leases do not affect assets and liabilities at the
inception of the lease. They are simply treated as rental agreements.
Dye (2002) studies the selection of accounting treatments using a model of
“classifications manipulation” in which accounting reports consist of one of two
treatments and accountants prefer one over the other. Dye (2002) finds that generally
accountants prefer operating leases to capital leases. Imhoff et al. (1991) investigate
how failing to capitalize operating leases that should be treated as capital leases can
materially distort the risk and performance measures of the firm. They document that
numerous firms in many different industries reported very large amount of non-
cancellable operating leases that last many years. Firms restructure the terms of most
leases that otherwise should be classified as capital leases to avoid the capitalization
requirements. By doing so, managers improve their firms’ reported performance and
leverage ratios. Bowman (1980) investigates the relationship between lease and the
market risk of the lessees and finds that the relationship between capital lease and
leverage is significant. Imhoff and Thomas (1988) examine the impact of “Accounting
for Leases” (SFAS No.13) on the lessees and find significant change in the lessees’
response to the promulgation of SFAS No.13. Before SFAS No.13 was adopted, most
leases that were hereafter “capital leases under SFAS No.13 were only disclosed in
footnotes. However, after adopting SFAS No.13, these previously off-balance-sheet
leases had to be reported on the face of the financial reports as capital leases. Because
of the above reasons, when SFAS No. 13 was adopted, the amount of reported new
capital leases has sharply declined and operating leases have significantly increased
correspondingly. So, the evidence of Imhoff and Thomas (1988) also suggest that
firms prefer operating leases over capital leases under SFAS No.13. Antle and Smith
(1986) find that return on asset ratio is the most important in evaluating the relative
performance of management. So, when compensation of managers is based on returns
on assets, they have incentives to keep assets used to generate profits off the balance
sheet and logically, they tend to report long-term leases as operating leases rather than
capital leases.

Experimental Task and Materials

Subjects are provided with description of a hypothetical company, the scenario of

a lease accounting case, a copy of the lease classification criteria for SFAS No.13 or
IAS 17, description of the management’ motivation (or the lack of) of the
94 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

hypothetical company and a description of the external auditor of the experimental

company. The lease accounting case can be accounted for aggressively (i.e., making an
operating leases choice) or conservatively (i.e., making a capital lease choice). The
subjects’ task is to make a lease accounting choice. The experimental materials are
presented in the appendices.

Experimental Procedure

Subjects are randomly assigned to one of the four groups: (1) “With motivation”
and “Under IAS 17,” (2) “With motivation” and “Under SFAS No.13”, (3) “Without
motivation” and “Under IAS 17,” and (4) “Without motivation” and “Under SFAS
No.13.” They are provided with different materials under different conditions. The
following is a summary of the experimental procedure:
1. Provide the general guidance for subjects on how to review the experimental
materials and complete the experimental task.
2. Provide the same background information of the experimental company and the
same lease accounting case to all subjects
3. Provide different descriptions of the management of the experimental company
to subjects who are under “With” motivation condition and who are under
“Without” motivation condition, respectively.
4. Provide different lease accounting standard to “Principles-based accounting
standard” and “Rules-based accounting standard” groups. In particular, the
“Rules-based accounting standard” group was provided with the U.S. lease
accounting standard SFAS No.13; and the “Principles-based accounting
standard” group was provided with the international lease accounting standard
IAS 17.
5. Ask all subjects to make lease accounting choice based on SFAS 13 or IAS 17.
6. Ask all subjects to justify their decision making. We ask subjects to answer
different justification questions under different manipulation conditions.
7. Ask all subjects to provide demographic information.

IV. RESULTS

Manipulation Checks

We perform three manipulation checks. First, we ask whether subjects have

followed either IAS17 or SFAS 13. All subjects answer “yes”. Second, we ask whether
subjects in the two “IAS 17” groups have exercise subjective judgment to interpret the
“major part” in IAS 17. All of them answer “yes.” Finally, we ask all subjects whether
the descriptions about the experimental company and their supervisor influence their
decision making by use a 5-point scale. The average score is 3.42 (“Yes, strong”),
which indicates subjects have noticed and taken into account the description of the
experimental company and their supervisor in making their decisions. The results of
the manipulation checks suggest that subjects indeed notice and use the manipulation
information when they made their decisions. Therefore, our manipulations were
successful.
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 95

Tests of Hypotheses

Hypothesis H1 suggests that managers are more likely to make aggressive

reporting decision when they have motivation to report aggressively than if they do
not have such motivation. H2 suggests that when managers have motivations to make
aggressive reporting decision, they are more likely to make an aggressive report under
a precise (i.e., rules-based) accounting standard than under an imprecise (i.e.,
principles-based) accounting standard. We run five regression models. The primary
regression model we use to test our hypotheses is:

Yi = α1 + β1Motivation + β2Standard + β3(Motivation x Standard) +ε I (1)

where
Yi = Lease accounting choice, coded as1 (operating lease), or 0 (capital lease);
Motivation = 1 (With Motivation), or 0 (Without Motivation);
Standard = 1 (Principles-based accounting), or 0 (Rules-based accounting)

H1 suggests that when management has the motivation to make an aggressive

reporting, the likelihood for them to do so is higher than if they do not have
motivation. The relationship between Motivation and Accounting choice is expected
to be positive. Therefore, H1 would be supported if β1 is positive and significant.
H2 suggests that when management have motivation to make aggressive
reporting decision (i.e., choosing operating lease), the likelihood for them to do so is
higher under rules-based accounting than under principles-based accounting. The
relationship between the “Motivation x Standards” (the interaction) and Accounting
Choice (Yi) is expected to be negative. H2would be supported if β3 is negative and
significant.

Descriptive Statistics and Chi-Square Test Results

Panels in Table 1 provide descriptive statistics about the assignments and

accounting decisions of participants in each of the 2x2 experimental groups and chi-
square tests of the influence of accounting standard types and motivation on
accounting choices. Panel A provides the number and the percentage of participants
who were assigned to the 2x2 experimental groups. In total, 96 accounting major
students participated and completed the experimental task in this study with number
of participants in each group ranging from 23 to 25. Twenty-five students are initially
assigned to each group but a total of 4 participants are dropped due to incomplete
response.
Panels B and C provide the descriptive statistics of those participants who decide
to record the lease as operating lease and those participants who choose a capital lease,
respectively. Out of all the 96 subjects, who are randomly assigned to one of the four
groups, slightly more subjects choose operating lease rather than capital lease (52
versus 44). The results also suggest that more subjects with motivation for aggressive
reporting choose operating lease than capital lease (n=32 for operating lease versus
n=16 for capital lease). The pattern for subjects without motivation is reversed but
with much smaller difference in the numbers of subjects (n=20 choosing operating
lease versus n=28 choosing capital lease). As for the effect of accounting standard
types, subjects following rules-based accounting (SFAS13) are more likely to report
96 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

aggressively by choosing operating lease accounting treatment (n=31) than subjects

following principles-based accounting (n=21). In contrast, the pattern is reversed for
subgroups of subjects making conservative reporting decision by choosing capital
lease treatment (n=16 for the SFAS13 group versus n=28 for the IAS17 group).
Out of the 52 subjects choosing operating lease (Panel B), motivation clearly
plays an important role. Thirty-two subjects have motivation to make aggressive
reporting decisions, while only 20 subjects do not have such motivation. The
accounting standard type exhibits similar pattern. Furthermore, there is a clear
interactive effect of motivation and accounting standard type on lease accounting
decisions of this group of subjects. There are 21 subjects who have motivation to
report aggressively do so under the rules-based accounting (i.e., SFAS13), while the
other three groups have similar and much smaller number of subjects (n=10 or 11).
These results are supported by the reverse distribution patterns of subjects who
choose the capital lease treatment (Panel C). The smallest sub-group (n=3) choosing
capital lease (conservative decision) is the one with motivation and under rules-based
accounting (SFAS 13), while the largest sub-group (n=15) choosing capital lease is the
one without motivation to report aggressively and following principles-based
accounting (IAS 17).
In order to more clearly see the influence of motivation on lease accounting
decision, we combine the four groups into two groups: with motivation versus
without motivation. We report the number (frequency) of the participants who
selected operating lease (proxy for aggressive reporting) and capital lease (proxy for
conservative reporting) under different motivation manipulation conditions in Panel
D, Table 1. When motivation factor is present for the 48 participants, 32 select
operating lease, while only 20 out of the other 48 participants select operating lease
when motivation factor is not present. The influence of motivation on aggressive
reporting is statistically significant (Chi-Square = 4.302, df =1, p=0.038; Panel E).
In Panel F and G, we report the descriptive statistics and Chi-Square test results
for the influence of the types of accounting standards on lease accounting decision. In
Panel F, we present the number of the participants who selected operating lease and
capital lease under different types of accounting standards, respectively. Among the 52
participants who select operating lease, 31 are in the U.S. GAAP groups, while only 21
are in the IFRS groups. The influence of the types of accounting standards on lease
accounting decision is statistically significant (Chi-Square = 5.097, df=1, p=0.024).
The Chi-Square test result is reported in Panel G. These results are consistent with the
regression results discussed below.

Table 1
Descriptive Results and Chi-Square Results
Panel A: Descriptive Statistics for Overall Sample (percentage, size)
Motivation
Accounting Standard Type Total
With Motivation Without Motivation
IFRS (IAS 17) 25.00% 26.00% 51.00%
(n=24) (n=25) (n=49)
U.S. GAAP (SFAS 13) 25.00% 24.00% 48.00%
(n=24) (n=23) (n=47)
Total 50% 50% 100%
(n=48) (n=48) (n=96)
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 97

Panel B: Descriptive Statistics for Participants Who Select Operating Lease (percentage, size)
Motivation
Accounting Standard Type Total
With Motivation Without Motivation
IFRS (IAS 17) 11.46% 10.42% 21.88%
(n=11) (n=10) (n=21)
U.S. GAAP (SFAS 13) 21.88% 10.42% 32.29%
(n=21) (n=10) (n=31)
Total 33.33% 20.83% 54.17%
(n=32) (n=20) (n=52)

Panel C: Descriptive Statistics for Participants Who Select Capital Lease (percentage, size)
Motivation
Accounting Standard Type Total
With Motivation Without Motivation
IFRS (IAS 17) 13.54% 15.63% 29.17%
(n=13) (n=15) (n=28)
U.S. GAAP (SFAS 13) 3.13% 13.54% 16.67%
(n=3) (n=13) (n=16)
Total 16.67% 29.17% 45.83%
(n=16) (n=28) (n=44)

Panel D: Descriptive Statistics for the Influence of Motivation on Lease Accounting

Decision(Frequency)
Lease Accounting Decision
Motivation Total
Capital Lease Operating Lease
With Motivation 16 32 48
Without Motivation 28 20 48
Total 44 52 96

Panel E: Chi-Square Tests (Influence of Motivation on Lease Accounting Decision)

Asymp.Sig
Value df
(2-sided)

Chi-Square 4.302 1 0.038

Panel F: Descriptive Statistics for the Influence of the Types of Accounting Standards on Lease
Accounting Decision (Frequency)
Lease Accounting Decision
Accounting Standard Type Total
Capital Lease Operating Lease
IFRS 28 21 49
U.S. GAAP 16 31 47
Total 44 52 96
Panel G: Chi-Square Test (Influence of the Types of Accounting Standards on Lease Accounting
Decision)
Asymp.Sig
Value df
(2-sided)

Chi-Square 5.097 1 0.024

98 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

Primary Regression Results

Table 2 present the results of the primary multiple-regression model specified in

equation (1). The results of the primary regression model suggest that motivations
significantly influence management’s accounting choice (β1 = 0.443, t = 3.204,
p=0.002). That is, if management has motivation to engage in aggressive reporting,
they are more likely to do so (by choosing the operating lease accounting treatment)
than if they do not have such motivation. Furthermore, there is significant interactive
effect between motivation and the type of accounting standard on management’s lease
accounting choice (β3 = -0.367, t = -2.194, p=0.0031). This result suggests that when
management has motivation to make aggressive reporting decision, they are more
likely to report aggressively if accounting standards are rules-based than if accounting
standards are principles-based. However, accounting standard types do not have
significant effect on management’s reporting decision.

Table 2
Primary Regression Model Results
Yi = α1 + β1 Motivation + β2 Standard + β3 Motivation x Standard +ε I
Model Coefficients t Sig.
Accounting_Standard 0.005 0.038 0.969
Motivation 0.443 3.204 0.002
Acctg_Std. x Motivation -0.367 -2.194 0.031

Additional Analysis

We also run several supplemental regression models to further test the

hypotheses (the results are not tabulated here for brevity). First, using the data from
the two “With Motivation” groups, we run the second regression model: Yi = β1 + β2
Accounting_Standard +ε i. The coefficient of Standard is -0.125 and significant at the
1% level (t=-3.341; p=0.002). This result suggests that when motivations exist, the
precision of accounting standards significantly influence management’s financial
reporting behavior. Second, using the data from the two “Without Motivation”
groups, we run the third regression model: Yi = β1 + β2 Standard +ε i. The coefficient
of Standard is 0.005 and not significant (t= 0.036; p=0.972). This result indicates that
when motivation does not exist, the type accounting standard do not significantly
influence manager’s accounting choices. Third, we run the regression model: Yi = β0
+ β1Motivation +ε i. The coefficient of Motivation is 0.230 and significant at the 5%
level (t=2.296, p=0.024). The result indicates that motivation significantly influence
management’s reporting choice. Based on the results of these supplemental regression
models, it is clear that motivation plays an important role in influencing management’s
accounting decision. Furthermore, motivation has greater impact on management’s
reporting decision under a rules-based accounting than under a principle-based
accounting. These results are consistent with results of the primary regression model.
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 99

Interpretation of “Majority” in IAS 17

The advocators of principles-based accounting believe that using verbal

thresholds may force management and accounting professionals to master the spirit of
an accounting standard rather than to confirm with the letter of an accounting
standard. However, the opponents of principles-based accounting argue that
management may take advantage of the flexibility inherent in a principles-based
accounting standard (Maines et al., 2003). In order to test whether participants have
the tendency to take advantage of the vagueness inherent in the verbal threshold,
“Majority,” in IAS 17, we run a Chi-Square test to check whether participants who
select operating lease interpret “Majority” significantly differently from those who
select capital lease. The Ch-Square test result (Chi-Square =7.553, df = 4, p= 0.109)
suggests that no significant difference exists. This result indicates that when a vague
threshold is presented to management, management may not take advantage of the
vagueness inherent in the standard to choose their favorite accounting treatment.
The descriptive statistics and Chi-Square test results are reported in Panels A and B,
Table 3.

Choice of “Useful Life”

The opponents of rules-based accounting believe that rules-based accounting

provides so many detailed directions (i.e., “bright lines”) that managers may follow to
achieve their favorite accounting treatment (Maines et al., 2003). In order to test
whether participants who have the desire to select operating lease tend to choose a
useful life that can help them to meet the numerical threshold of “75%” in SFAS 13,
we run a Chi-Square test to check whether participants who select operating lease
choose the “useful life” significantly different from those who select capital lease. The
Ch-Square test result (Chi-Square =17.464, df = 4, p= 0.001) suggests that
participants’ choice of “Useful life” is significantly different when they made different
lease accounting decisions. These results indicate that when a precise numerical
threshold is presented to management, management tends to meet the threshold by
using accounting estimate to choose their favorite accounting treatment.
The descriptive statistics and Chi-Square test results are reported in Panels C and D,
Table 3.

Table 3
Descriptive Statistics and Chi-Square Tests for Participants' Interpretation of
"Majority" and Choice of "Useful Life"
Panel A: Descriptive Statistics for Participants' Interpretation of "Majority" (Frequency)
Lease Accounting Decisions
Interpretation
of Majority Capital Lease Operating Lease Total
> 50% 16 5 21
≥ 60% 2 4 6
≥ 70% 8 10 18
≥ 80% 1 2 3
≥ 90% 0 1 1
Total 27 22 49
Note: 2 participants in the "IFRS" groups did not answer the question regarding the interpretation of "Majority"
100 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

Panel B: Chi-Square (Interpretation of "Majority" and Lease Accounting Decision)

Asymp.Sig
Value df
(2-sided)

Chi-Square 7.553 4 0.109

Panel C: Descriptive Statistics for Participants' Choice of "Useful Life" (Frequency)

Lease Accounting Decisions
Useful Life Total
Capital Lease Operating Lease
6 21 6 27
7 3 10 13
7.5 11 18 29
8 2 4 6
9 6 15 21
Total 43 53 96
Panel D: Chi-Square ( Choice of "Useful Life" and Lease Accounting Decision)
Asymp.Sig
Value df
(2-sided)

Chi-Square 17.464 4 0.002

Additional Analysis of Major Demographic Questions

We run additional Chi-Square tests to check if gender, age, and class standing of
participants are significantly different across different groups. We find that no
significant difference exists. The results indicate that the random assignment is
successful. We also test whether the external auditing environment influences
participants’ lease accounting decision. In the experiment, the participants are
informed that their lease accounting choice would be reviewed by the company’s
external auditor who is a CPA from a Big 4 accounting form. After participants have
made their lease accounting decision, they were asked to indicate to whether their
lease accounting decision is influenced by the description of the external auditing
environment. The result (Chi-Square = 5.381, df = 4, p =0.25) suggests marginally
significant influence of the external auditing environment on lease accounting
decision. The descriptive statistics and Chi-Square test results are reported in Table 4.

Table 4
Results of The Influence of External Auditing Environment on Lease
Accounting Decision
Influence of External Lease Accounting Decisions
Auditors Capital Lease Operating Lease Total
1 11 9 20
2 3 12 15
3 14 13 27
4 9 13 22
5 6 6 12
Total 43 53 96
 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011) 101

Table 4 (continued)
Value Df Asymp.Sig
(2-sided)
Chi-Square 5.381 4 0.25
Note: Scale for Influence of External Auditors: 1 = Not at all; 5 = very Strong.

V. SUMMARY AND CONCLUSIONS

The recent and frequent occurrence of accounting scandals leads to the passage
of the Sarbanes-Oxley Act in an attempt to strengthen the current U.S. financial
accounting and reporting system. The FASB has also decided to make the current U.S.
GAAP more principles-based to converge with the international accounting standards.
The presumption underlying this action by the FASB is that principles-based
accounting standards may help mitigate aggressive financial reporting. We examine
whether this presumption is supported empirically -- whether the likelihood for
management to make aggressive accounting choice is lower under principles-based
accounting than under rules-based accounting when motivation to report aggressively
or conservatively is incorporated in the experimental methodology. Motivated
reasoning theory is the theoretical foundation of this study.
Motivated reasoning theory suggests that people believe what they want to
believe as long as they are able to construct a seemingly reasonable justification.
Motivation and the possibility for people constructing a reasonable justification play
critical roles in people’s judgment and decision making. Rules-based accounting
standards characterized by “bright lines” and “numerical thresholds” have provided
management with accurate goals. These goals clearly “tell” management what need to
be done in order to choose their favorite accounting treatments without being
questioned by the company’s independent auditor. Therefore, rules-based accounting
makes it easier for management to construct a seemingly reasonable justification if
they have a motivation to do so. However, principles-based accounting system do not
provided management with such accurate targets. The imprecision of accounting
standards makes it more difficult for management to construct a seemingly objective
justification even if they have the motivation to do so. We believe that motivation
plays an important role in management’s accounting reporting behavior. When
managers have a motivation to prepare accounting reports aggressively, it would be
more likely and easier for them to do so under rules-based than principles-based
accounting.
Consistent with our predictions, the results show that management with
motivation for aggressive reporting is less likely to make aggressive reporting decision.
Furthermore, the effect of motivation on aggressiveness of reporting is more
pronounced when more principles-based accounting standard is to be followed than
when more rules-based accounting standard is to be applied. However, when there is
no such motivation, the likelihood for management to report aggressively, when
applying more principles-based accounting, is not significantly different than such
likelihood when applying more rules-based accounting. Overall, these findings are
consistent with the predictions of the motivated reasoning theory, which underlies our
research hypotheses.
Our findings have implications for accounting standard setters, regulators and
future research. With respect to standard setters, our findings support their efforts in
switching from rules-based accounting to principles-based accounting. Compared
102 Grace and Jerry/Journal of Accounting – Business & Management vol. 18 no. 2 (2011)

with rules-based accounting, principles-based accounting indeed reduces the

likelihood for management/accounting preparers to report aggressively, especially
when motivation for aggressive (or conservative) reporting is taken into account.
Future empirical research may test if applying a principles-based accounting improves
the quality of accounting information in the U.S. Our findings should be of interest to
U.S. regulators. Motivation plays an important role in the aggressiveness of financial
reporting. What to do to control or reduce management’s motivation should be one
of the major issues the U.S. regulators should contemplate in the future. As suggested
by Nelson (2003), if accounting standard setters and regulators desire conservative (or
less aggressive) financial reporting, they are most likely to achieve this objective by
combining standards that are imprecise enough to avoid precise safe harbors and
vigorous enforcement that shifts the balance of incentives away from aggressive
reporting and toward conservative or accurate reporting.
The study has the limitations common to most experimental studies. Besides
those common limitations, other limitations of this research are: (1) Senior accounting
students do not have as much experience as accounting practitioners; (2) The size of
subjects is not large, although not too small compared to many prior studies; (3) We
do not manipulate the accounting environment. For example, we do not consider the
influence on management’s reporting decision of oversight by the board of directors
that plays an important role in the financial reporting process; (4) we do not ask
subjects to make their accounting decision based on all four criteria but on only one
of the criteria in accounting standard for leases. The reason for doing so is to simplify
the experiment but it may affect the generalizability of this study’s findings.

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