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 managements 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 managements 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 principlesbased 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 managements 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

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managements 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 managements 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 peoples judgment and decision (Bonner, 2008). For example, Cuccia et al. (1995) find that motivation influences tax practitioners 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 managements 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

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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 managements 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--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

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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 managements 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 managements financial reporting choice. While motivated reasoning theory has been applied in prior accounting studies to explore how accounting professionals 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 managements 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 managements behavior (Libby and Lipe, 1992).

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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 humans 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 principlesbased accounting may mitigate aggressive reporting. Webster and Thornton (2005) find that Canadas 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).

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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 managements 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 managements 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 managements 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 managements 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-

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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

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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 Ashtons (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

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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. Managements 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

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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 firms debt to equity ratio and decrease its return on assets ratio, and that affects negatively investors perception of the firms 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 noncancellable 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

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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.

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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 = 1 + 1Motivation + 2Standard + 3(Motivation x Standard) + 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 1 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 3 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 chisquare 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

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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) Accounting Standard Type IFRS (IAS 17) U.S. GAAP (SFAS 13) Total Motivation With Motivation 25.00% (n=24) 25.00% (n=24) 50% (n=48) Without Motivation 26.00% (n=25) 24.00% (n=23) 50% (n=48) Total 51.00% (n=49) 48.00% (n=47) 100% (n=96)

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

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

Panel D: Descriptive Statistics for the Influence of Motivation on Lease Accounting Decision(Frequency) Motivation With Motivation Without Motivation Total Lease Accounting Decision Capital Lease 16 28 44 Operating Lease 32 20 52 Total 48 48 96

Panel E: Chi-Square Tests (Influence of Motivation on Lease Accounting Decision) Value Chi-Square 4.302 df 1 Asymp.Sig (2-sided) 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 IFRS U.S. GAAP Total Capital Lease 28 16 44 Operating Lease 21 31 52 Total 49 47 96

Panel G: Chi-Square Test (Influence of the Types of Accounting Standards on Lease Accounting Decision) Value Chi-Square 5.097 df 1 Asymp.Sig (2-sided) 0.024

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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 managements accounting choice (1 = 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 managements lease accounting choice (3 = -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 managements reporting decision. Table 2 Primary Regression Model Results
Yi = 1 + 1 Motivation + 2 Standard + 3 Motivation x Standard + I Model Accounting_Standard Motivation Acctg_Std. x Motivation Coefficients 0.005 0.443 -0.367 t 0.038 3.204 -2.194 Sig. 0.969 0.002 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 = 1 + 2 Accounting_Standard + 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 managements financial reporting behavior. Second, using the data from the two Without Motivation groups, we run the third regression model: Yi = 1 + 2 Standard + 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 managers accounting choices. Third, we run the regression model: Yi = 0 + 1Motivation + 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 managements reporting choice. Based on the results of these supplemental regression models, it is clear that motivation plays an important role in influencing managements accounting decision. Furthermore, motivation has greater impact on managements reporting decision under a rules-based accounting than under a principle-based accounting. These results are consistent with results of the primary regression model.

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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) Interpretation of Majority Lease Accounting Decisions 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"

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Panel B: Chi-Square (Interpretation of "Majority" and Lease Accounting Decision) Value Chi-Square 7.553 df 4 Asymp.Sig (2-sided) 0.109

Panel C: Descriptive Statistics for Participants' Choice of "Useful Life" (Frequency) Useful Life 6 7 7.5 8 9 Capital Lease 21 3 11 2 6 Lease Accounting Decisions Operating Lease 6 10 18 4 15 Total 27 13 29 6 21

Total 43 53 96 Panel D: Chi-Square ( Choice of "Useful Life" and Lease Accounting Decision) Value Chi-Square 17.464 df 4 Asymp.Sig (2-sided) 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 companys 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 Auditors 1 2 3 4 5 Total Lease Accounting Decisions Capital Lease Operating Lease 11 9 3 12 14 13 9 13 6 6 43 53 Total 20 15 27 22 12 96

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Table 4 (continued)
Value Chi-Square 5.381 Df 4 Asymp.Sig (2-sided) 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 peoples 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 companys 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 managements 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

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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 managements 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 managements 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 studys findings. REFERENCES Ashton, R. H. "Judgment Formation in the Evaluation of Internal Control: An Application of Brunswik's Lens Model." Ph.D. dissertation, University of Minnesota, 1973. Ashton, R.H. and S. Kramer. 1980. Students as Surrogates in behavioral Accounting Research: Some Evidence. Journal of Accounting Research. 18 (1):1-15 Antle, R. and A. Smith. (1986). An Empirical Investigation of the Relative Performance Evaluation of Corporate Executives. Journal of Accounting Research. Vol.24; No.1; p1-39. Barth, M., W. Landsman, and M. Lang (2008) . Accounting Quality: International Accounting Standards and US GAAP. Working paper. http://sbm.temple.edu/conferences/cav/2008/documents/barthpaper.pdf Bonner, S. (2008). Knowledge and Personal Involvement in Judgment and Decision Making in Accounting. Pearson and Prentice Hall, Upper Saddle River, New Jersey 07458 Bowman, R.G. (1980). The Debt Equivalence of Leases: An Empirical Investigation. The Accounting Review. Vol. LV. No. 2; p237-253 Cuccia, A.D., K, Hackenbrack, and M.W. Nelson. (1995). The Ability of Professional Standards to Mitigate Aggressive Reporting. The Accounting Review. Vol. 70 (2); p227-248 Dye, R.A. (2002). Classifications Manipulation and Nash Accounting Standard. Journal of Accounting Research. Vol. No. 40. September 2002. p 1125-1162

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The Security Exchange Committee (SEC). Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. www.sec.gov/news/studies/principlebasedstand.htm Webster, E and D.B. Thornton (2005). Earnings Quality under Rules- versus Principles-based Accounting Standards: A Test of the Skinner Hypothesis. Canadian Accounting Perspectives, 2005, Vol. 4 Issue 2, p167-192.

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