The impact of principles-based vs rules-based accounting standards on reporting quality and earnings management

Abstract

Purpose The purpose of this paper is to explore whether principles-based vs rules-based accounting standards have an effect on measures of financial reporting quality and earnings management strategies. Design/methodology/approach This study uses a firm-year-specific variable that captures the extent to which firms’ accounting and operating behavior is affected by the characteristics of a specific standard in the USA. Measures of absolute accruals, financial misconducts, signed abnormal accruals and abnormal cash flows are used to assess the effects. Findings The results show that absolute magnitude of accruals and probability of financial misconduct is lower, and accrual earnings management is higher when firms’ standards are more based on principles. The study also suggests that potentially costlier real earnings management is a consequence of rules-based standards. Research limitations/implications This study relies heavily on measures from the prior accounting literature, hence, care has been exercised in generalizing the findings. Practical implications This study has direct implications for a number of stakeholders, including standard setters, policymakers, securities regulators, researchers, investors, financial statement preparers and auditors. For example, the future development of accounting standards can be supported by the empirical conclusions in this study together with previous standard-setting ambitions, commentaries, experiments and analytical work. Originality/value This study extends prior single-country studies on reporting quality and cross-country studies on transition effects of firms switching from local to International Accounting Standards by observing the impact of accounting standard characteristics on additional measures of reporting quality and accrual as well as real earnings management when holding institutional factors constant. The study also offers archival evidence complementing prior commentaries, experiments and analytical work.

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