Principles-Based Standards and Earnings Attributes

Abstract

This study examines the relation between principles-based standards and earnings attributes. We create a firm-year-specific variable that measures the extent to which firms’ financial reporting is affected by principles-based standards. We find that firms’ earnings are more informative and persistent and have a larger positive association with future cash flows, on average, when firms’ standards are more principles based. We also find evidence that managers use the added discretion provided by principles-based standards to manage earnings when firms are near bankruptcy, issuing equity, or experiencing high growth, and if earnings are near prominent earnings benchmarks. Overall, our evidence is consistent with managers using the discretion provided by principles-based standards to communicate better the economic substance of transactions, on average, but also with some managers using the added discretion strategically when managerial incentives exist to increase reported earnings. Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2016.2465 . This paper was accepted by Mary Barth, accounting.