ACCOUNTING WORKSHOP A Model of Principles-Based vs. Rules-Based Standards

We develop a theoretical framework to examine the trade-offs between principlesbased standards and rules-based standards. By relying on quantifiable evidence, a rules-based standard induces evidence management whereas by relying on the auditor’s professional judgement, a principles-based standard induces audit failure. Given evidence management and audit failure, we derive the optimal standard and show that it combines both principles-based and rules-based elements in a simple way: when the evidence is unfavorable, the standard prescribes an unfavorable treatment to a transaction but when the evidence is favorable, it leaves the treatment of the transaction to the auditor’s professional judgement. We demonstrate that the standard relies more on the auditor’s professional judgement as (1) the effectiveness of the regulatory enforcement increases, (2) the cost of evidence management increases, and (3) the cost of undue optimism errors decreases and/or the cost of false alarm errors increases. ∗Preliminary and Incomplete.