Principles-Based Accounting Standards, Earnings Management and Price Efficiency

Abstract

The issue of principles-based accounting standards has been attracting growing interest since the emergence of the International Financial Reporting Standards (IFRS) as a global phenomenon, and the United States consideration of IFRS adoption. This paper studies the effect of a move towards principles-based accounting standards on price efficiency in the equity market. I assume a move towards principles-based standards requires the firm’s manager to use more of his private, though more subjective, information for financial reporting. I model the manager’s reporting decision as a trade-off between increased compensation through earnings management and a cost associated with earnings management (such as litigation, SEC enforcement, and manipulation effort). I find that the effect of a move towards principles-based accounting standards on price efficiency is non-monotonic. When standards are highly rules-based, reducing the use of rules-based standards increases price efficiency. However, at some point, this relation reverses. The optimal mix of rules and principles reflects a trade-off between two types of effects on price efficiency: predictive ability and comparability.  In addition, expected earnings management is non-monotonic in the use of rules-based standards. Finally, I find that rules intensity and managerial compensation incentives act as complements, such that higher managerial compensation incentives require more rules-based standards for price efficiency to be maximized.