BEHAVIORAL RESEARCH IN ACCOUNTING American Accounting Association

Vol. 24, No. 1 DOI: 10.2308/bria-50071

2012
pp. 2546

In GAAP We Trust: Examining How Trust

Influences Nonprofessional Investor Decisions
Under Rules-Based and Principles-Based
Standards
Wendy J. Bailey
Northeastern University
Kimberly M. Sawers
Seattle Pacific University

ABSTRACT: In this study, we investigate whether and how trust in our current, more
rules-based financial reporting system and type of accounting standard affects
nonprofessional investor decision making. In an experiment, 151 nonprofessional
investors analyzed two companies that were economically identical except for a single
underlying financial reporting difference that allowed one company to more positively
report its financial results. By itself, the type of standard (rules-based, principles-based)
did not affect investment choices or allocation decisions. However, when trust was
considered, nonprofessional investors who are less trusting of our current financial
reporting system chose to invest in a company with more positive financial results only
when evaluating principles-based financial statements. Conversely, the type of standard
did not affect investor decision making for nonprofessional investors who trust our
current financial reporting system. These results have implications for standard setters
as we move to a more principles-based accounting system.
Keywords: rules-based standards; principles-based standards; institutional trust;
procedural justice.

Data Availability: Available on request.

INTRODUCTION
The primary question to answer is whether principles-based standards will improve the quality of
information in the market place. The discussion cannot be had in a vacuum at 50,000 feet, but must
focus on comparisons of the same standard drafted as rules-based versus principles-based.
Marc E. Lackritz, Financial Accounting Standards Advisory Council (FASAC) (2002) Survey

We thank Theresa Libby (editor) and two anonymous reviewers for their helpful comments and suggestions. We also
thank Allen Blay, Jake Birnberg, Lynn Hannan, Sarah Hasley, Vicky Hoffman, Don Moser, Andrew Spicer, Ross
Stewart, Scott Vandervelde, Pete Wilson, Arnie Wright, WWMA, and Tina Zamora, as well as workshop participants at
Boston College, University of California, Riverside, University of Pittsburgh, University of South Carolina, and the
Financial Accounting and Reporting Conference at the AAA Annual Meeting for comments on earlier drafts. Financial
support was provided by University of California, Riverside, Academic Senate Research Grants.

Published Online: December 2011

25
26 Bailey and Sawers

F
inancial reporting, accounting standards, auditing practices, and corporate governance came
under increased scrutiny in the aftermath of the Enron and WorldCom accounting scandals.
Investor confidence in the quality of financial information declined and the accounting
professions reputation suffered (Rapoport and Whitman 2002). In an effort to restore trust in the
financial reporting system, the Financial Accounting Standards Board (FASB) proposed a
principles-based approach to U.S. accounting standards, and continues to move toward
convergence with International Financial Reporting Standards (IFRS) (Securities and Exchange
Commission [SEC] 2003; Cox 2006; U.S. Chamber of Commerce 2006; Kroeker 2007).1
Endorsing a principles-based accounting system assumes that principles-based standards improve
the quality and transparency of financial information and, correspondingly, user decision making
(Schipper 2002; Rapoport and Whitman 2002; Burns 2002; Baker 2002). However, financial
statement users often do not see through accounting choices and judgments (Healy and Wahlen
1999; Daniel et al. 2002), and the type of standard alone may not help them see through the
financial reporting choices.
Decision makers often need additional motivation to examine financial information more
thoroughly (Dearman and Shields 2005). We argue that a lack of trust in our current, more
rules-based financial reporting system is a situational characteristic that may provide sufficient
incentive for users to more thoroughly examine financial reporting choices. Trust is the willingness
of one individual to rely on others or information created by others (Mayer et al. 1995). When an
individual does not trust a financial reporting system, he or she may be unwilling to invest in a
company that reports more favorable financial results unless the accounting standards used to
produce those results are different from the current system. That is, the lack of trust may encourage
more scrutiny, which may help investors analyze and understand the financial information better
and, as a result, potentially make better decisions. We examine whether and how trust and type of
standard influence investors decisions.
In this study, we investigate whether the type of standard (rules-based, principles-based) and
the degree of trust in our current, more rules-based financial reporting system (more trusting, less
trusting) affect nonprofessional investor judgments and decisions. Nonprofessional investors were
provided either rules-based or principles-based financial statements, but not both, for two
companies (ABC, XYZ). Both companies were economically identical except for one financial
reporting choice. One company (ABC) used the latitude in the accounting standards to report more
positive financial results (i.e., higher EPS and better financial ratios).2 Investors were then asked to
invest in one of the two companies and to allocate investment dollars between the two companies.
We find that for participants who are more trusting of our current financial reporting system, the
type of standard did not affect their willingness to invest in a company reporting more positive
financial results. However, participants who are less trusting of our current financial reporting
system chose to invest in, and allocate more investment dollars to, the company with more positive
financial results only when evaluating principles-based statements.

1
Accounting standards in the U.S. are often characterized as being more rules-based, while international
accounting standards are characterized as more principles-based. While all accounting standards should be based
on principles, a rules-based accounting standard is one that contains specific guidelines, elaborate rules, or clear
thresholds (bright-line) that tend to remove or reduce the level of judgment required to administer the
standard, contain more scope and legacy exceptions, have excessive implementation guidance, and excessive
detail (SEC 2003).
2
The categorization of more positive is consistent with prior experimental work on earnings management (e.g.,
Cuccia et al. 1995). In addition, Jamal and Tan (2010) use the term aggressive reporting for any reporting
choice that biases toward an outcome consistent with managements incentives, such as reporting a lease-type
transaction off balance sheet.

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Volume 24, Number 1, 2012
In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 27

This paper makes a contribution to both accounting literature and the standard-setting process,
especially the current debate over rules-based versus principles-based standards. Although the type
of standard alone does not help users see through financial reporting choices, when the type of
accounting standard is considered in conjunction with trust in the financial reporting system, lack of
trust in the current financial reporting system provides motivation for some investors to more
thoroughly examine financial reporting choices. Previous research has demonstrated an individuals
feelings and general engagement with an interesting task (i.e., intrinsic motivation) helps users see
through financial accounting choices (Dearman and Shields 2005). We extend this research by
focusing on trust as a situational characteristic that is generated by a circumstance and not the task
itself. It is the engagement with this situational characteristic that provides the motivation to look
beyond the reporting choices. Thus, the focus on trust as a situational characteristic adds to the
literature on factors that may create motivation to overcome accounting fixation.
In the next section of this paper, we develop theory and hypotheses for investor behavior. The
third section discusses the experimental research design and participant selection. The fourth
section presents the results, and the conclusion is presented in the fifth section.

THEORY AND HYPOTHESES DEVELOPMENT

Investor confidence has declined as a result of recent accounting scandals (Hodge 2003). In
hopes of restoring investor trust, the FASB and the SEC are in the process of changing our current,
more rules-based financial reporting system to a more principles-based financial reporting system.
Supporters of principles-based accounting standards argue that the current financial reporting model
has too many complex rules (Schipper 2002; Rapoport and Whitman 2002; Dow Jones Newswire
2002) and encourages managers to manipulate financial results by structuring transactions around
the rules (Burns 2002). Such supporters believe that principles-based standards will be more
understandable and make it more difficult to structure transactions (Baker 2002). Conversely, critics
have expressed concern that principles-based standards will leave too much room for professional
judgment, causing a significant diversity in application, reducing comparability, consistency, and
regulatory enforcement (Schipper 2003; Berkowitz and Rampell 2002a, 2002b; Baker 2002; Herz
2002). These critics are skeptical that principles-based standards will lead to better quality financial
reporting, and some simply do not believe companies and their auditors can be trusted to exercise
professional judgment.
Whether rules-based or principles-based, prior research suggests that managers and accounting
professionals use the latitude in accounting standards, either judgment in applying principles or
structuring transactions around rigid rules, to manage earnings and support aggressive financial
reporting (Salterio and Koonce 1997; Nelson and Kinney 1997; Hackenbrack and Nelson 1996;
Hoffman and Patton 2002; Nelson et al. 2002, 2003). Further, prior research has shown that
investors do not perfectly see through financial reporting choices and can be fooled by earnings
management (Healy and Wahlen 1999; Daniel et al. 2002).3 Financial reporting differences have
influenced perceptions of reliability, quality, confidence, transparency, and stock price judgments
(Hopkins 1996; Maines et al. 1997; Hirst and Hopkins 1998). However, there has been little
research about whether the type of standard, rules-based or principles-based, will change how
nonprofessional investors use financial statements to make decisions (Maines et al. 2003).

3
The definition of earnings management from Healy and Wahlen (1999): earnings management occurs when
managers use judgment in financial reporting or in structuring transactions to alter financial reports either to
mislead some stakeholders about the underlying economic performance of the company or to influence
contractual outcomes that depend on reporting accounting numbers.

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Volume 24, Number 1, 2012
28 Bailey and Sawers

While many advocates of principles-based and rules-based standards believe the type of
standard will make a difference in financial reporting decisions, Jamal and Tan (2010) find that the
type of standard alone does not affect managers proclivity to undertake aggressive financial
reporting choices. Further, because users tend to fixate on accounting information as presented, they
may not adjust for the effects of different accounting methods or reporting choices (Hopkins 1996;
Maines et al. 1997; Hirst and Hopkins 1998; Daniel et al. 2002).4 That is, fixation may inhibit
investors from seeing through financial reporting differences, regardless of the type of standard
used to prepare the financial statements.
Dearman and Shields (2005) argue that accounting fixation may be overcome if an individual
has the appropriate knowledge, expertise, and sufficient intrinsic motivation to exert additional
effort.5 In this study, we focus on lack of trust as a situational characteristic or factor that creates
motivation to overcome fixation. Trust is the willingness to take risk or to be vulnerable to the
actions of another (Mayer et al. 1995). Investing decisions require individuals to be willing to take
on some risk and to be vulnerable or rely on others. Research in procedural justice indicates that
individuals are remarkably willing to accept rules, procedures, and standards at face value, and may
believe that they function as indicated until there is overwhelming evidence to the contrary (Lind
and Tyler 1988). Thus, investors who trust a financial reporting system are more likely to accept the
financial reports and rely on summary financial measures (i.e., accounting fixation). In this study,
we focus on lack of trust as a situational characteristic or factor that creates motivation to overcome
fixation.
The type of standard alone may not increase the likelihood that an investor will be able to see
through financial reporting choices. If investors trust the financial reporting system and fail to
recognize financial reporting choices, they are more likely to place higher value on a company with
more positive financial results, regardless of the type of standard used to generate those financial
results. Thus, our first hypothesis is as follows:
H1a: Nonprofessional investors who are more trusting of the current financial reporting
system will make similar investment decisions when given financial information created
using principles-based or rules-based standards.
While the type of standard alone may not affect investing decisions, the type of standard can
interact with other factors to facilitate a difference in decision making. Jamal and Tan (2010) find
that when rules-based standards are used, the type of auditor (rules-oriented, principles-oriented, or
client-oriented) does not influence managers propensity to take aggressive financial reporting
positions. However, when principles-based standards are used, managers take less aggressive
reporting positions when an auditor is principles-oriented than when the auditor is either
rules-oriented or client-oriented. Further, aggressive reporting was lowest with a principles-based
accounting standards and principles-oriented auditor combination than any other standards and
audit type combination.
We believe that a lack of trust is a situational factor that will interact with type of standard and
generate different investor decisions. Specifically, a lack of trust in a financial reporting system may

4
Consistent with Dearman and Shields (2005), we use the term accounting fixation to describe an individuals
persistent focus on accounting information as presented, and the failure to adjust the information for differences
in accounting method choices and reporting choices. Other terms used in prior accounting literature have been
functional fixation, data fixity, and fixate on current knowledge structures.
5
Dearman and Shields (2005) focus on intrinsic motivation or the feeling of satisfaction, competency, and
control of freedom that results from completing an interesting task. That is, if the individual is engaged with the
task, it is more likely that the individual will exert more effort, be more creative, and, in turn, overcome or avoid
accounting fixation.

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 29

provide sufficient motivation for an individual to avoid accounting fixation. A lack of trust occurs
when an individual relies on another party and perceives that party has an incentive to mislead the
individual (Rousseau et al. 1998; Shapiro et al. 1992). Given recent accounting scandals and
documented efforts to manage earnings, some nonprofessional investors may believe managers
have an incentive to mislead them, while auditors and regulators are unable or unwilling to do
anything about it.
When individuals do not trust the outcomes, they exert more scrutiny on the process by which
those outcomes are derived (Lind and Tyler 1988). Thus, a lack of trust may shift investor effort
away from relying on financial results and toward the process by which those results are created.
This scrutiny may lead to investors making different decisions depending on the type of standard
used to create the financial statements. Investors with a lack of trust in the current, more rules-based
financial reporting system may view financial information created using rules-based statements as
suspect, and not trust the information presented.
Schoorman et al. (2007) argue that control systems bridge the gap between risk and trust by
lowering perceived risk to a level manageable by trust. Accounting standards represent a control
system which minimizes risk and allows investors to trust in the information financial statements
represent. If one control system is not perceived to be working, a replacement system may
resolve the perceived risk, generate trust, and reduce perceptions of risk (Chiles and McMackin
1996). As a result, investors who lack trust in the current, more rules-based financial reporting
system will be more likely not to trust information generated by rules-based standards. However,
if that trust is restored with information generated by principles-based standards, investors are
likely to make different investment decisions than when trust is not restored (rules-based
standards).
In H1a, we argued that if nonprofessional investors trust the current financial reporting system,
they are more likely to place higher value on a company with more positive financial results
regardless of how the financial results are generated. When trust is high, investment decisions
should be similar regardless of the type of standard; however, when trust is low, we expect the type
of standard to matter. When trust is restored via principles-based standards, investors will choose to
place higher value on a company with more positive financial results than when trust is not restored.
As a result, we predict that when trust in the current, more rules-based financial reporting system is
low and nonprofessional investors receive financial information generated by a competing
(principles-based) system, nonprofessional investors will invest more in a company with more
positive financial results. Thus, our second hypothesis is as follows:
H1b: Nonprofessional investors who are less trusting of the current financial reporting system
will make different investment decisions when given financial information created using
principles-based versus rules-based standards.

METHOD
Participants
A total of 331 experimental packets were distributed to nonprofessional investors in the
western United States. We use nonprofessional investors because concerns about restoring investor
confidence in the financial reporting system are especially relevant to the nonprofessional investor.6

6
Christopher Cox, Chairman of the SEC, stated regarding American investors: It is chiefly to serve those people
that the SEC exists. Our missionto protect investors, promote capital formation, and maintain orderly
marketsmust always put ordinary Americans first. (Cox 2006)

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30 Bailey and Sawers

In addition, nonprofessional investors are increasing in numbers (SEC 2001, 3) and use different
valuation models than professional investors (Fredrickson and Miller 2004). One hundred sixty-two
packets were returned, for an overall response rate of approximately 48.9 percent. Of the 162
responses, 11 participants did not complete the experimental materials, leaving a final sample of
151 participants. Fifty-two of the participants were offered a chance to participate through
investment groups or university alumni lists.7 Most of these participants were offered a charitable
donation as an incentive to complete the experimental materials. The remaining 99 participants
were asked to participate through M.B.A. classes. Most of these participants were offered extra
credit as an incentive to complete the experimental materials.
As reported in Table 1, the investment group participants were significantly more likely to be
male (Chi-square 27.04, p , 0.01), and report significantly more work experience (Chi-square
16.60, p , 0.01), investing experience (Chi-square 9.90, p , 0.01), and buy/sell transactions
(Chi-square 3.14, p , 0.01) than the M.B.A. group participants. Investment group participants
were also less likely to have taken accounting classes (Chi-square 9.01, p , 0.01), but more
likely to routinely analyze financial investments (Chi-square 31.51, p , 0.01) than the M.B.A.
group participants. Finally, investment group participants were significantly more likely to take
longer to complete the experimental materials (Chi-square 3.83, p , 0.01) than the M.B.A. group
participants. Given these significant differences between the investment group and M.B.A. group
participants, group (investment, M.B.A.) was entered as a between-subject factor in the data
analysis. The results indicate there is no group main effect or interactive effects (p . 0.10 for all
effects). These results are consistent with the findings of Elliott et al. (2007) that M.B.A. students
with significant work experience (greater than five years), accounting classes (introduction and
financial analysis), or a combination of both made similar investment-related judgments and
decisions as nonprofessional investors. Accordingly, the investment group and M.B.A. group
participants will be analyzed as a single participant pool.8

Experimental Design
We use a 2 3 2 experimental design with type of standard (rules-based, principles-based) and
trust (more trusting, less trusting) as between-subject factors. Type of standard is a manipulated
factor, while trust is a measured factor, split into more trusting and less trusting using cluster
analysis. Participants were asked to analyze the financial statements (balance sheet, income
statement, statement of cash flows, notes to financial statements) of two similar companies (ABC,
XYZ), created using either rules-based or principles-based standards. An investment choice and the
allocation of investment dollars between two companies (ABC, XYZ) are used as dependent
measures.
The financial statements for ABC and XYZ were similar except for one underlying financial
reporting difference. The XYZ financial statement values were initially created by multiplying the
ABC financial statement values by 1.67. Therefore, although XYZ appeared larger, all accounting
ratios presented in the experimental materials were initially the same. At this point, one accounting
issue (leases, subsidiaries, revenue recognition for multiple deliverables) was used to create a single

7
All participants received a self-contained experimental packet with instructions and experimental materials.
Although most of the investment group participants completed the materials on their own time, it is unlikely that
they had contact with other participants. Most of the M.B.A. student participants completed the materials during
class time, which precluded them from discussing the materials with other students.
8
In addition, work experience, gender, investing experience, buy/sell transactions, accounting experience, and
self-reported analytical experience were used as covariates in the data analysis. There were no significant main
effects or interactive effects ( p . 0.10 for all effects).

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 31

TABLE 1
Demographics by Group
Statistic
Investment Groups M.B.A. Students (p-value)
Number of Participants 52 99
Gender
Male 46 49 27.04
(88.5%) (49.5%)
Female 6 50
(11.5%) (50.5%) (0.00)
Work Experience 32.1 years 7.1 years 16.60
(9.45) (6.93) (0.00)
Investing Experience 20.0 years 4.0 years 9.90
(12.01) (4.06) (0.00)
Buy/Sell Transactions 17.76 6.65 3.14
(20.84) (16.00) (0.00)
Accounting Classes
Zero 16 11 9.01
(30.8%) (11.1%) (0.00)
One to Three 26 65
(50.0%) (65.7%)
Four or More 10 23
(19.2%) (23.2%)
Analyzing Investments
Rely on Others 1 27 31.51
(1.9%) (27.3%) (0.00)
Beginning to Analyze 12 43
(23.1%) (43.4%)
Routinely Analyze 39 29
(75.0%) (29.3%)
Time to Complete 35.78 minutes 27.63 minutes 3.83
(10.53) (7.94) (0.00)

underlying reporting difference between ABC and XYZ.9 That is, after the financial statements for
XYZ were created, the financial statements for ABC were adjusted as though ABC used the latitude
in the accounting standard to report higher earnings per share and better financial ratios.10 If ABC
reported operating leases, then XYZ reported capital leases. If ABC reported subsidiaries under the

9
We used three accounting issues so that two of the issues could be used to introduce the participants to rules-
based and principles-based standards prior to the experiment, and the remaining issue could be used to create an
underlying financial reporting difference between ABC and XYZ. Each of the three accounting issues was used
to create an underlying financial reporting difference, and participants were randomly assigned to one of the three
issues. However, there were no significant differences across accounting issues and, therefore, the type of
accounting issue will not be analyzed separately. However, using three different issues created a slightly
different EPS for each issue. As a result, we control for the EPS variance by using EPS as a covariate.
10
Rules-based standards provide latitude for managers to structure transactions around the rules in order to affect
the financial information. Principles-based standards provide latitude for managers to exercise judgment in order
to affect the financial information.

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32 Bailey and Sawers

equity method, then XYZ would report subsidiaries under consolidation. If ABC reported multiple
deliverables as a single product at the point of sale (all revenue), then XYZ reported multiple
deliverables as separate products at the point of sale (part revenue and part deferred revenue). This
single underlying reporting difference improved the resulting earnings per share and financial
statement ratios for ABC Company.11 Accordingly, ABC is considered the company that reports
more positive financial results.
The type of standard (rules-based, principles-based) was manipulated by preparing financial
statements for both companies (ABC, XYZ) using either rules-based or principles-based standards.
That is, participants evaluated the financial statements of two different companies prepared either as
rules-based or principles-based, but not both. To establish the financial statements as either rules-
based or principles-based, the notes to the financial statements presented detailed information about
all three accounting issues (leases, subsidiaries, revenue recognition for multiple deliverables). To
operationalize principles-based standards, the financial statement note described the principle
(objective) and then stated in our judgment to indicate the accounting treatment chosen.12 To
operationalize rules-based standards, the financial statement note described the rule (bright-line)
and then stated, as a result, they must treat the transaction in a certain way to indicate the
accounting treatment chosen.13
As presented in Appendix A, the underlying financial reporting difference could be identified
via the notes to the financial statements. The balance sheet, income statement, and financial ratios
for ABC principles-based statements (XYZ principles-based statements) are the same as the balance
sheet, income statement, and financial ratios for ABC rules-based statements (XYZ rules-based
statements). The only difference between rules-based and principles-based financial statements is
how the financial statement notes were written. To help participants understand the difference
between rules-based and principles-based standards, a learning segment was completed prior to the
experiment. This learning segment helped participants become familiar with rules-based and
principles-based accounting standards, although the standards were never identified as rules-based
or principles-based. We used three standards, two of which were used in the learning segment, and
the remaining standard was used to create the single underlying financial reporting difference in the
experimental task.
Based on Dearman and Shields (2005), accounting fixation may be overcome by appropriate
knowledge, expertise, and sufficient motivation. As described above, in our experiment, we make
sure that participants have knowledge (learning task) and expertise (investment experience), and
that knowledge and expertise are not different across conditions. We argue that lack of trust is a
factor that provides motivation to overcome fixation. Trust in the current financial reporting system
was measured by having participants indicate, on a scale of 1 (strongly disagree) to 7 (strongly

11
The financial statements of both ABC and XYZ reported all three accounting issues (leases, subsidiaries,
multiple deliverables). However, two of the three accounting issues were reported identically for ABC and XYZ.
Only the remaining issue (which was not used in the learning segment) was used to create a financial reporting
difference between the two companies.
12
Our notes were designed to meet the definition of principles-based or objective-oriented standards suggested by
SEC Study Pursuant to Section 108(d) (SEC 2003). Principles-based standards typically have a clearly stated
objective, based on improved and consistently applied conceptual framework, provide sufficient detail and
structure so standard can be operationalized, minimize exceptions, and avoid use of percentage tests or bright-
line rules.
13
Using the notes to the financial statement to describe use of judgment ( principles-based) or compliance with a
rule (rules-based) is a good proxy for the type of standard, because principles-based standards denote use of more
judgment and rules-based standards denote following a specific set of rules. Since financial statements (balance
sheet and income statement) created under principles-based or rules-based standards would look similar, it is
likely that the only place the type of standard would be evident would be in the notes to the financial statements.

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 33

agree), whether they trusted financial statement information, managers preparation of financial
statements, auditors correcting of financial misstatements, and regulatory enforcement.14

Procedures
Each participant received a self-explanatory case packet that included a cover letter explaining
the nature of the study, an informed consent statement, experimental materials, and a pre-addressed,
stamped return envelope. The experimental materials were divided into three sequentially marked
packets: Part 1 contained the learning segment followed by a demographic questionnaire, Part 2
contained the main experimental task for this study, and Part 3 contained a post-experimental
questionnaire.15
In Part 1, participants reviewed two of three accounting issues, one written as a rules-based
standard and the other written as a principles-based standard. The rules-based standards were
written to emphasize relatively elaborate rules, and the principles-based standards were written to
emphasize the underlying principle or objective (see Appendix B for an example). This learning
task served to expose the participants to different types of standards. Each participant was asked
to rate the discretion, perceived fairness, and perceived quality (relevance, reliability,
verifiability, neutrality, comparability, understandability) of each accounting standard. Finally,
participants were asked to complete a demographic questionnaire indicating their work
experience, level of education, number of accounting classes, gender, and level of investment
experience. The demographic questionnaire also served as a distraction task between the learning
task and the main experimental task.
In Part 2, participants were told that they were considering an investment in one (or both) of
two companies in the medical supply industry. Both companies had performed above the industry
average, competed in similar markets, produced similar products and services, and maintained
subsidiary relationships with key suppliers. Participants were then asked to analyze the financial
statements (balance sheet, income statement, statement of cash flows, notes to financial statements)
of two companies (ABC, XYZ).16 Finally, participants were asked to choose to invest in either
ABC or XYZ, and allocate a hypothetical $10,000 investment between ABC and XYZ.
In Part 3, the post-experimental questionnaire, participants were asked to indicate whether they
noticed (noticed, did not notice, did not recall) the underlying financial reporting difference between
the two companies (ABC, XYZ). As a manipulation check, participants were asked to rate, on a
scale of 1 (none) to 7 (a lot), how much discretion the financial statement preparers used to prepare
the financial statements of ABC and XYZ, and to rate the quality (relevance, reliability,
verifiability, neutrality, comparability, understandability) of the financial statements for both ABC
and XYZ. Finally, participants were asked to indicate their level of trust in financial information,
managers preparation of financial statements, auditors correcting financial misstatements, and
regulatory enforcement.

14
The questions were prefaced with focusing on your own experience, apart from the study you have just
completed, please rate the following statements to create a distinction between their trust in the financial
reporting system and the experiment itself.
15
Participants were instructed to replace all materials from each part back into the original packet to further
emphasize the separation of tasks.
16
Participants were reminded that the notes to the financial statements report accounting policies and treatment for
a number of balance sheet and income statement items, and that Generally Accepted Accounting Standards
(GAAP) require management to make estimates and judgment that may affect assets, liabilities, revenue, and
expense. We gave this reminder to make the importance of examining the notes to the financial statements more
salient.

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34 Bailey and Sawers

RESULTS
Manipulation Check
Rules-based and principles-based accounting standards differ in the degree of discretion
allowed managers in preparing financial statements. Participants were asked to rate, on a scale of 1
(none) to 7 (a lot), how much discretion was used to prepare the financial statements for ABC and
XYZ.17 Participants indicated that the discretion used to prepare principles-based financial
statements for ABC (mean 4.50, STD 1.21) and XYZ (mean 4.63, STD 1.19) was
significantly greater (F 6.65, p 0.01) than the discretion used to prepare rules-based financial
statements for ABC (mean 4.03, STD 1.35) and XYZ (mean 4.27, STD 1.32). There was no
significant difference in discretion ratings between the two companies, nor was there any difference
due to the level of trust (p . 0.10 for all effects). These results indicate that the participants
responded to the type of standard manipulation and recognized a difference in discretion between
the rules-based and principles-based financial statements, but did not attribute such a difference in
discretion to either of the companies or the level of trust.18

Covariate
This experiment is designed to examine whether trust and the type of accounting standard,
rules-based or principles-based, affect nonprofessional investor judgments and decisions. Based on
the theoretical background and hypothesis development, EPS was identified and used in the data
analysis to control for possible confounds and to provide insight into the decision-making process.
Cognitive theory suggests that nonprofessional investors may fixate on accounting information and
rely on summary measures such as EPS or financial ratios. The reported EPS and financial ratios for
each company are highly correlated and, therefore, only EPS will be used as the covariate. In
addition, because ABC reports more positive financial results and uses the latitude in the accounting
standards to report higher EPS, the EPS for ABC will be entered as a covariate. Using the EPS for
ABC also controls for any possible financial differences across accounting issues.19

Hypotheses Testing
H1a and H1b predict that investment decisions depend on the level of trust in our current, more
rules-based financial reporting system (more trusting, less trusting) and the type of accounting
standard (rules-based, principles-based). To test these hypotheses, participants were split into more
trusting and less trusting of the current financial reporting system. Participants were asked to rate
their trust in financial statement information, trust in managers preparation of financial statements,
trust in auditors correcting financial misstatements, and the trust in regulatory enforcement on a
scale of 1 (strongly disagree) to 7 (strongly agree). A factor analysis was completed, indicating that
the four trust items were highly correlated and loaded on a single factor accounting for 61 percent of
the variance. A reliability test of these four trust items yields a Cronbachs alpha of 0.78, indicating
a high degree of internal consistency among items.

17
All p-values are one-tailed unless otherwise indicated.
18
In Part 1, we asked participants to rate, on a scale of 1 (not very) to 7 (very), how much discretion the accounting
standard allowed financial statement preparers, to determine if they could distinguish between the rules-based
and principles-based standards. Participants rated principles-based standards (mean 4.48, STD 1.71) as
having significantly more discretion (t 2.28, p 0.01) than rules-based accounting standards (mean 4.03,
STD 1.72), indicating that participants were able to distinguish between the two types of standards.
19
The quality, fairness, and discretion ratings assessed in the learning phase of the study were also tested as
possible covariates. There were no significant main effects or interactive effects ( p . 0.10 for all effects) and,
therefore, the results of the learning segment will not be further analyzed.

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A two-step cluster analysis was then completed using the mean value for the four trust items,
resulting in two significantly different groups (t 16.64, p , 0.01): less trusting (mean 3.34,
STD 0.77) and more trusting (mean 5.10, STD 0.53). As reported in Table 2, the cluster
analysis results did not differ by the type of standard for the more-trusting group (t 1.00, p
0.323, two-tailed) or for the less-trusting group (t 0.46, p 0.645, two-tailed).20 As a further
check, participants were asked to indicate the perceived overall quality of the current financial
reporting system on a scale of 1 (very poor) to 7 (very high). Participants who were less trusting of
the current financial reporting system (mean 3.39, STD 1.10) indicated significantly lower
quality of financial reporting (t 5.89, p , 0.01) than those who were more trusting of the current
financial reporting system (mean 4.40, STD 0.91).21
To test H1a and H1b, participants were asked to choose to invest in a single company (ABC,
XYZ). Overall, as reported in Table 3, 119 (78.8 percent) out of 151 participants preferred to invest
in ABC regardless the type of standard or the level of trust.22 Fifty-six out of 72 (77.8 percent) of
the participants who are more trusting of the current financial reporting system chose to invest in
ABC rather than XYZ; the choice to invest in ABC was similar for both rules-based and principles-
based standards (Chi-square 0.01, p 0.916, two-tailed). These results are consistent with H1a.
Similarly, 63 out of 79 (79.7 percent) of the participants who are less trusting of the current
financial reporting system also chose to invest in ABC rather than XYZ. However, participants who
are less trusting of the current financial reporting system were significantly more likely (Chi-square
5.40, p 0.020, two-tailed) to invest in ABC when evaluating principles-based financial
statements (93.0 percent) than when evaluating rules-based financial statements (63.9 percent).
These results support H1b. Overall, this pattern of investment choice is marginally significant (Chi-
square 2.96, p 0.085, two-tailed) and again supports H1a and H1b.23
Participants were also asked to allocate $10,000 between ABC and XYZ. To examine
investment allocations for rules-based versus principles-based financial statements, an ANCOVA

20
Any difference between the more-trusting and less-trusting groups is not explained by gender (Chi-square 2.29,
p 0.13), the number of accounting courses (Chi-square 0.20, p 0.66), the self-reported investment analysis
experience (Chi-square 0.25, p 0.62), the number of buy/sell transactions (t 0.63, p 0.53), or the time to
complete the experimental materials (t 0.70, p 0.49). While the years of work experience (t 1.68, p 0.10)
and years of investing experience (t 1.58, p 0.12) do differ between more-trusting and less-trusting groups,
these differences appear to be due to three participants in the less-trusting group with over 40 years of work and
investing experience. Eliminating these participants does not inferentially change the reported results.
21
Sensitivity analysis was performed using different clustering techniques and cluster sizes. Results were
inferentially similar to those reported. Individual trust items do not differ by level of trust across the type of
standard ( p . 0.10, all effects) except across the regulation dimension for the more-trusting group ( p 0.054,
two-tailed). However, using different clustering techniques and cluster sizes, this difference disappears. Further,
using individual trust items instead of the trust scale produces inferentially similar results.
22
The choice to invest in ABC rather than XYZ was not driven by years of work experience (t 0.62, p 0.54),
years of investing experience (t 0.66, p 0.51), number of buy/sell transactions (t 0.69, p 0.49), gender
(Chi-square 0.87, p 0.35), number of accounting classes (Chi-square 0.21, p 0.65), self-reported
investing analysis experience (Chi-square 0.44, p 0.92), or time to complete the experimental materials (t
1.09, p 0.28).
23
Our study focuses on whether the interaction between trust in our current financial reporting system and the type
of accounting standard influences the patterns of investment decisions. Therefore, we do not make a formal
prediction regarding the difference in investment choices between more- and less-trusting participants under
rules-based standards (78.4 percent versus 63.9 percent). It is arguable that if a participant is less trusting of
rules-based standards, he or she might want to avoid the higher performing company (ABC) due to concerns that
the companys performance was manipulated. However, while ABC might be reporting aggressively, they were
not reporting fraudulently. Since financial reporting differences are fully disclosed, participants, in theory,
should have been indifferent between choosing ABC or XYZ. Without the restoration of trust via a different
accounting standard, our theory does not predict which company participants will choose to invest in. Our results
are consistent with this explanation because we find that the percentage of less-trusting participants who chose
ABC under rules-based standards (63.9 percent) is not statistically different from 50 percent ( p . 0.10).

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36 Bailey and Sawers

TABLE 2
Dimensions of Trust
Type of Standarda
Rules-Based Principles-Based
b
More Trusting n 37 n 35
Information 5.22 Information 5.06
(0.79) (0.84)
Managers 4.89 Managers 4.86
(0.77) (0.85)
Auditors 5.30 Auditors 5.40
(0.85) (1.01)
Regulate 4.76 Regulate 5.34
(1.34) (1.19)
Meanc 5.04 Meanc 5.16
(0.57) (0.47)
Less Trustingb n 36 n 43
Information 3.53 Information 3.40
(1.11) (1.16)
Managers 2.92 Managers 2.88
(1.03) (1.16)
Auditors 3.42 Auditors 3.42
(1.38) (1.14)
Regulate 3.31 Regulate 3.79
(1.31) (1.51)
Meanc 3.29 Meanc 3.37
(0.79) (0.75)
a
Type of Standard refers to whether the financial statements were written as rules-based or principles-based.
b
Level of Trust is based on the cluster analysis for a scale of 1 (strongly disagree) to 7 (strongly agree) for each of four
items (trust in financial statement information, trust in managers preparation of financial statements, trust in auditors
correcting financial misstatements, trust in regulatory enforcement).
c
No differences across type of standard (p . 0.10, one-tailed), but significant differences across Level of Trust (p ,
0.10, one-tailed).

was performed using the dollar values allocated to ABC, the more positive company, as a
dependent measure,24 and type of standard (rules-based, principles-based) and trust (more trusting,
less trusting) as the between-subject factors. EPS was entered as a covariate. As reported in Table 4,
the ANCOVA results for the ABC investment allocation indicate a non-significant effect for type of
standard (F 0.24, p 0.314). Participants evaluating rules-based financial statements allocate
similar amounts to ABC (marginal mean $6,265) as participants evaluating principles-based
financial statements (marginal mean $6,427). These results, combined with the main effect for
EPS (F 9.51, p , 0.01), are consistent with a fixation explanation. That is, that the type of
standard alone will not help participants see through financial reporting choices.
As depicted in Figure 1, the significant type of standard by trust interaction (F 2.80, p
0.048) suggests that investment allocations depend on both the type of standard and the level of

24
Because the participants were asked to allocate $10,000 between ABC and XYZ, it is only necessary to analyze
the amount invested in one of the two companies, and since most participants chose ABC, we will analyze the
amount invested in ABC.

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TABLE 3
ABC Investment Choice (Percentage)a
Panel A: ABC Investment Choice (Percentage)
Type of Standardb
Rules-Based Principles-Based Total
c
More Trusting 29 of 37 27 of 35 56 of 72
(78.4%) (77.1%) (77.8%)
Less Trustingc 23 of 36 40 of 43 63 of 79
(63.9%) (93.0%) (79.7%)
Total 52 of 73 67 of 78 119 of 151
(71.2%) (85.9%) (78.8%)

Panel B: Chi-Square Results for ABC Investment Choice

Chi-Square p-valued
Type of Standard 1.38 0.241
Level of Trust 0.02 0.879
Type of Standard 3 Level of Trust 2.96 0.085
More Trusting: Rules-Based versus Principles-Based 0.01 0.916
Less Trusting: Rules-Based versus Principles-Based 5.40 0.020
Rules-Based: More Trusting versus Less Trusting 1.48 0.224
Principles-Based: More Trusting versus Less Trusting 1.49 0.223
a
ABC Investment Choice is the participants choice to invest in ABC (as opposed to XYZ).
b
Type of Standard refers to whether the financial statements were written as rules-based or principles-based.
c
Level of Trust is based on the cluster analysis for a scale of 1 (strongly disagree) to 7 (strongly agree) for each of four
items (trust in financial statement information, trust in managers preparation of financial statements, trust in auditors
correcting financial misstatements, trust in regulatory enforcement).
d
All p-values are two-tailed.

trust. However, simple effects tests indicate that participants who are more trusting of the current
rules-based financial reporting system allocate similar amounts of money to ABC (t 0.68, p
0.207) when evaluating rules-based financial statements (mean $6,400, STD $2,098) and
principles-based financial statements (mean $6,006, STD $2,179). These results are consistent
with H1a. For less-trusting participants, the reverse is true. Less-trusting participants allocate
significantly more money to ABC (t 2.44, p = 0.061) when evaluating principles-based financial
statements (mean $6,848, STD $1,824), but less money to ABC when evaluating rules-based
financial statements (mean $6,131, STD $2,282). These results support H1b. Thus, the form of
the type of standard by level of trust appears to be ordinal. Testing the form of the interaction using
contrast weights of 1, 1, 3, and 1, yields a significant result (t 1.95, p 0.027). Taken
together, these results are consistent with and support the predictions in H1a and H1b.

Alternative Explanations
Two alternative explanations are consistent with the results presented above: (1) the ability to
see through financial reporting differences differs by type of standard, and (2) perceived quality and
performance differ by the type of accounting standard. First, the ability to identify underlying
financial reporting differences often allows participants to incorporate knowledge in subsequent
investment decisions. In the post-experiment questionnaire, participants were asked whether they

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38 Bailey and Sawers

TABLE 4
ABC Investment Allocationa

Panel A: ANCOVA Results for ABC Investment Allocationa

df MS F p-valuee
b
Type of Standard 1 977,543 0.24 0.314
Level of Trustc 1 3,026,829 0.73 0.200
Type of Standard 3 Level of Trust 1 11,565,399 2.80 0.048
Covariated
EPS 1 38,194,859 9.51 0.001
Error 146 4,127,551

Panel B: Simple Effects for Investment Allocation for ABCa

F p-valuee
More Trusting: Rules-Based versus Principles-Based 0.68 0.207
Less Trusting: Rules-Based versus Principles-Based 2.44 0.061
Rules-Based: More Trusting versus Less Trusting 0.32 0.287
Principles-Based: More Trusting versus Less Trusting 3.28 0.036

Panel C: Adjusted Mean (Std. Dev.) for Investment Allocation for ABCa
Type of Standardb
Rules-Based Principles-Based Marginal Mean
c
More Trusting $6,400 $6,006 $6,203
(2,098) (2,179)
n 37 n 35
Less Trustingc $6,131 $6,848 $6,489
(2,282) (1,824)
n 36 n 43
Marginal Mean $6,265 $6,427
a
Investment Allocation is the portion of a $10,000 investment allocated to ABC Company.
b
Type of Standard refers to whether the financial statements were written as rules-based or principles-based.
c
Level of Trust is based on the cluster analysis for a scale of 1 (strongly disagree) to 7 (strongly agree) for each of four
items (trust in financial statement information, trust in managers preparation of financial statements, trust in auditors
correcting financial misstatements, trust in regulatory enforcement).
d
EPS for ABC is used as a covariate.
e
All p-values are one-tailed unless otherwise noted.

noticed the underlying financial reporting difference between ABC and XYZ. The proportion of
participants who identified the underlying reporting difference was not significantly different (Chi-
square 0.14, p 0.71, two-tailed) for rules-based financial statements (n 32) and principles-
based financial statements (n 30).25 To further investigate, we reanalyzed the statistics using those

25
In addition, the ability to identify such differences is not explained by the years of work experience (t 1.62, p
0.11), gender (Chi-square 0.13, p 0.72), the number of accounting classes (Chi-square 0.00, p 0.99), the
self-reported investment analysis experience (Chi-square 1.73, p 0.19), the years of investing experience (t
1.87, p 0.06), the number of buy/sell transactions (t 0.38, p 0.70), or the time to complete the
experimental materials (t 1.15, p 0.25).

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 39

FIGURE 1
ABC Investment Allocationa

a
Investment allocation is the portion of a $10,000 investment allocated to ABC Company.

participants who identified the underlying financial reporting difference between ABC and XYZ.
The (untabulated) ANCOVA results for investment allocation indicate non-significant effects for
type of standard, trust, and EPS (p . 0.10 for all effects), and a significant interaction type of
standard by trust (F 1.94, p 0.085).
Second, perceptions of financial statement quality are developed at the same time as
perceptions of financial performance and, therefore, any differences in perceived quality or
performance could affect investment decisions. To examine the effect of perceived quality, the
mean quality rating for the six quality dimensions (relevance, reliability, verifiability, neutrality,
comparability, and understandability) was calculated for each company.26 A comparative quality
measure was then created by comparing the perceived quality of the ABC financial statements with
the perceived quality of the XYZ financial statements. The (untabulated) ANCOVA results for the

26
A factor analysis indicates that the six quality dimensions for each of ABC and XYZ are highly correlated and
load on a single factor accounting for approximately 63 percent of the variance. A reliability test of the six
quality dimensions yielded a Cronbachs alpha greater than 0.88, indicating a high degree of internal consistency
among the seven quality dimensions. Accordingly, we use the mean quality score as our measure.

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40 Bailey and Sawers

comparative quality measure indicate non-significant effects for type of standard, trust, and the type
of standard by trust interaction (p . 0.25 for all effects). A similar comparative firm performance
measure was created by comparing the perceived performance of ABC with the perceived
performance of XYZ. The ANCOVA results for the comparative performance measure indicate
non-significant effects for type of standard, trust, and type of standard by trust interaction (p . 0.25
for all effects). Accordingly, it is not the difference in perceived quality or performance that drives
the differential results across the type of standard and the degree of trust.27

CONCLUSION
Discussion
The purpose of this study is to investigate whether and how the type of standard (principles-
based, rules-based) and the degree of trust in the current financial reporting system affect
nonprofessional investor judgments and decisions. We find that although principles-based
accounting standards clearly allow more discretion than rules-based standards, the type of standard
alone did not affect the investment decisions of nonprofessional investors. Nonprofessional
investors who are generally more trusting of our current, more rules-based financial reporting
system chose to invest in the company and allocated investment dollars in a similar manner,
regardless of the type of standard used to generate the financial results. However, the reverse was
true for those who are less trusting of the current financial reporting system. Less-trusting
participants chose to invest and allocate more money to the company reporting more positive
financial results when evaluating principles-based financial statements than when evaluating rules-
based financial statements. These results are consistent with the procedural justice and institutional
trust literature. When rules and procedures fail to produce fair outcomes, decision makers shift
focus from the outcomes to the process (Lind and Tyler 1988). Changing the process generates trust
and reduces perceived risk and, as a result, individuals become more willing to rely on the
information generated by that process (Schoorman et al. 2007).

Limitations
There are several limitations to this study. First, trust in the financial reporting system is a
measured variable rather than a manipulated variable. Measured variables often raise questions
about possible omitted variables. However, given the lack of demographic differences across the
more- and less-trusting groups, we believe such omitted variables are minimal, at best. At the same
time, future research might consider manipulating trust rather than measuring trust. Further, we
specifically chose to measure trust after the experimental task was completed. We acknowledge that
it is generally preferable to elicit trust prior to the experimental task. However, measuring trust prior
to the task runs the risk of priming the participant to consider trust throughout the remainder of the
task. Measuring trust after the task runs the risk that the task influences the participants response to
the trust measure. We chose to measure trust after the task to keep from priming the participants,
but we realize that the task may have influenced the trust measure. However, we did test to make
sure that the task or type of standard did not drive our measure of trust.

27
Note that one of our experimental design choices was to measure trust in the financial reporting system at the end
of the experiment. One potential limitation of this choice was that participants would answer the trust questions
in response to the experimental materials, rather than focusing on their trust in the financial reporting system in
general. The results indicate that the performance and quality measures did not vary across differing levels of
trust, which gives us some confidence that the participants did respond to the trust questions as their trust in the
system in general and not to the specific firms in the experiment.

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 41

Second, we argue that if participants do not trust one accounting standard system, a
replacement system may resolve the perceived risk and lack of trust. Our theory, however, does not
specify what type of replacement system and we acknowledge that there are potentially a number of
alternative systems. Given that both the FASB and the International Accounting Standards Board
(IASB) are continuing to shift from rules-based standards to principles-based standards, we
believed it was important to focus this study on these two systems. However, it might be interesting
to investigate whether similar results can be achieved with another alternative system or multiple
alternative systems.
Third, in the learning section prior to the experimental task, we asked participants to rate two
accounting standards, one written as a rules-based standard and one written as a principles-based
standard, on the degree of discretion, perceived fairness, and perceived quality. A potential
limitation is that the learning section could have primed the participants to consider accounting
standards and their impact on the quality of financial reporting, which they may not have otherwise
considered. We took steps to minimize this impact by adding a distraction task and by using the
results from the learning section as covariates in the experimental analysis. There were no
significant main or interactive effects and, therefore, we concluded that the learning segment did not
affect the results of the experiment. However, we acknowledge that even with these precautions,
participants could have been primed to consider information quality.
Finally, participants were forced to allocate investment money and were not allowed to invest
outside the two companies provided. Such a forced allocation was chosen to simplify the analysis.
However, future research should address whether the lack of trust forces participants out of the
market entirely. As we try to further understand the relation between trust and different financial
reporting systems, we need to expand the types of investment opportunities available to
participants.

Future Research
Given the concerns about the credibility of the U.S. financial reporting system, future research
should investigate the link between trust in the current, more rules-based financial reporting system
and the demand for principles-based accounting standards. In addition, we are just beginning to
investigate the role of rules-based standards versus principles-based standards in the U.S. financial
reporting system, and future research should address other aspects of the preference for a type of
standard and its impact on decision making. Further, our study focuses on individual responses to
trust and type of accounting standard, but we cannot directly extrapolate how trust or lack of trust
might affect capital markets. Robert Shiller (2009) argues that trust is a key component of
individual behavior, especially as it relates to fiscal decisions. He further argues that large groups of
individuals with different levels of trust might drive entire markets (e.g., recent examples in the real
estate and capital markets); however, this assertion is yet to be empirically tested. Finally, there are
other aspects of the Sarbanes-Oxley Act that attempt to restore trust in the financial reporting
system. Future research should focus on the role of trust, the ability of the proposed changes to
restore trust, and the impact of trust on different types of judgments and decisions.

Conclusion
This study contributes to the current debate on principles-based versus rules-based accounting
standards. The FASB is moving forward with a more principles-based approach to U.S. accounting
standard setting as a means of increasing the quality of financial reporting and restoring trust in the
current financial reporting system. We find that trust plays a role in nonprofessional investors
willingness to rely on financial information and, as a result, to invest. For the nonprofessional
investor who has lost faith and trust in our current, more rules-based financial reporting system,

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42 Bailey and Sawers

switching to a more principles-based system might generate the trust necessary for the
nonprofessional investor to invest more money. However, standard setters should also remember
that if changing to a more principles-based financial system causes nonprofessional investors to lose
faith and trust in the U.S. financial reporting system, those investors might actually invest less
money.
In a review of academic literature, to gain an understanding of how rules-based and principles-
based standards would influence financial reporting, Maines et al. (2003) state that the two
different approaches to accounting standards alter neither the incentive nor ability of management
to report opportunistically; only the nature and character of the opportunistic reporting. They go
on to state that the research provides some evidence that the rigid (bright-line) or flexible nature of
the governing accounting standard is important, but generally less important than incentives faced
by both managers and auditors. Similarly, we have found that the two different approaches to
accounting standards do not change the ability of investors to see through financial reporting
information; rather, it is the level of investor trust that determines reliance and acceptance of
financial reporting information.

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pdf

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APPENDIX A
EXAMPLES OF FINANCIAL STATEMENT NOTES FOR SUBSIDIARIES
Principles-Based Condition
ABC: Notes to Consolidated Financial Statements
Note 2: Supply Chain Investments
Compuchip Tech Inc.ABC Medical Supply owns 46 percent of the outstanding common
stock Compuchip Tech Inc. Investments are classified based on the level of control exerted by the
parent. The ability to influence an entity, but not control it, requires the equity method. The
investment is recorded at the cost of the shares acquired on the balance sheet, and is subsequently
increased (decreased) by the parents share of the earnings of the subsidiary and decreased by all
dividends received from the subsidiary. In our judgment, we do not have the ability to control
Compuchip. A summary of financial information for Compuchip is as follows (in thousands):

Current assets $1,700 Net operating revenues $11,000

Noncurrent assets 15,000 Cost of goods sold 7,000
Total assets 16,700 Gross profit 4,000
Current liabilities 1,250 Operating income 800
Noncurrent liabilities 12,000 Net income $350
Total liabilities 13,250 Company equity income $161
Shareowners equity $3,450
Company equity investment $1,500

Note 5: Other Unaudited Information and Ratio Analysis

Profit Margin 15.38% Return on Equity 49.72%

Asset Turnover 1.25 Long-Term Debt to Equity 0.53
Return on Assets 19.30% Current Ratio 1.05

XYZ: Notes to Consolidated Financial Statements

Note 2: Supply Chain Investments
Technochip Inc.XYZ Medical Supply owns 50 percent of the outstanding common stock of
Technochip Inc. Investments are classified based on the level of control exerted by the parent. The
ability to control the policies and management requires consolidated financial statements.
Consolidated financial statements treat the parent and the subsidiary as a single entity. The assets
and liabilities of the subsidiary are reported on the parents balance sheet. Similarly, the revenue
and expenses of the subsidiary are reported on the parents income statement. A minority interest is
reported on the balance sheet and income statement for any interest not owned by the parent. In our
judgment, we have the ability to control the policies of Technochip Inc.

Note 5: Other Unaudited Information and Ratio Analysis

Profit Margin 8.06% Return on Equity 43.94%

Asset Turnover 0.97 Long-Term Debt to Equity 2.85
Return on Assets 7.78% Current Ratio 1.12

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In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions 45

Rules-Based Condition
ABC: Notes to Consolidated Financial Statements
Note 2: Supply Chain Investments
Compuchip Tech Inc.ABC Medical Supply owns 46 percent of the outstanding common
stock Compuchip Tech Inc. Investments are classified based on the percentage ownership held by
the parent. A 2050 percent ownership interest requires the equity method. The investment is
recorded at the cost of the shares acquired on the balance sheet, and is subsequently increased
(decreased) by the parents share of the earnings of the subsidiary and decreased by all dividends
received from the subsidiary. Compuchip supplies 70 percent of the computer technology for our
products, helping to ensure high-quality inputs. A summary of financial information for Compuchip
is as follows (in thousands):

Current assets $1,700 Net operating revenues $11,000

Noncurrent assets 15,000 Cost of goods sold 7,000
Total assets 16,700 Gross profit 4,000
Current liabilities 1,250 Operating income 800
Noncurrent liabilities 12,000 Net income $350
Total liabilities 13,250 Company equity income $161
Shareowners equity $3,450
Company equity investment $1,500

Note 5: Other Unaudited Information and Ratio Analysis

Profit Margin 15.38% Return on Equity 49.72%

Asset Turnover 1.25 Long-Term Debt to Equity 0.53
Return on Assets 19.30% Current Ratio 1.05

XYZ: Notes to Consolidated Financial Statements

Note 2: Supply Chain Investments
Technochip Inc.XYZ Medical Supply owns 50 percent of the outstanding common stock of
Technochip Inc. Investments in a subsidiary are classified based on the percentage ownership held
by the parent. A 50 percent ownership interest requires consolidated financial statements.
Consolidated financial statements treat the parent and the subsidiary as a single entity. The assets
and liabilities of the subsidiary are reported on the parents balance sheet. Similarly, the revenue
and expenses of the subsidiary are reported on the parents income statement. A minority interest is
reported on the balance sheet and income statement for any interest not owned by the parent.

Note 5: Other Unaudited Information and Ratio Analysis

Profit Margin 8.06% Return on Equity 43.94%

Asset Turnover 0.97 Long-Term Debt to Equity 2.85
Return on Assets 7.78% Current Ratio 1.12

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APPENDIX B
EXAMPLE OF ACCOUNTING ISSUE FOR PART 1
Accounting For Leases (Rules-Based)
Definition
A lease is a contractual agreement conveying the right to use property, plant, and equipment for
a specified period of time.

Standard
Leases are classified as either capital or operating leases. At inception, a lease that meets one or
more of the following four criteria is classified as a capital lease. Leases that do not meet one of the
four criteria listed below should be classified as operating leases.
1. The lease transfers ownership of the asset.
2. The lease contains a bargain purchase option.
3. The lease term is equal to 75 percent or more of the estimated economic life.
4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair
value of the asset.
Method
Capital leases should be accounted for by recording an asset and a liability on the balance sheet
at the lower of (1) the present value of the minimum lease payments, or (2) the fair value of the
leased asset. Subsequent lease payments are allocated between a reduction of the lease liability and
interest expense. In addition, the capital lease asset is depreciated over the lease term.
Operating leases should be accounted for as lease expense on the income statement. In
addition, a note disclosure of the future minimum lease payments is required.

Accounting for Leases (Principles-Based)

Definition
A lease is a contractual agreement conveying the right to use property, plant, and equipment for
a specified period of time.

Standard
Leases are classified as either capital or operating leases. Leases that transfer substantially all of
the benefits and risks of property ownership should be classified as capital leases. Leases that do not
transfer substantially all benefits and risks of ownership should be classified as operating leases.

Method
Capital leases should be accounted for by recording an asset and a liability on the balance sheet
at the lower of (1) the present value of the minimum lease payments, or (2) the fair value of the
leased asset. Subsequent lease payments are allocated between a reduction of the lease liability and
interest expense. In addition, the capital lease asset is depreciated over the lease term.
Operating leases should be accounted for as lease expense on the income statement. In
addition, a note disclosure of the future minimum lease payments is required.

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Volume 24, Number 1, 2012
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