The Effect of Tightening Accounting Standards on the Quality of the Reported Earnings and the Level of Earnings Management

Abstract

This paper constructs a one-period model of a reporting game where the manager is risk neutral and the asset market is perfectly competitive. The manager chooses the level of the accounting earnings to report to the market in order to influence the market value of the firm. The reported earnings number is transmitted to the market through earnings fixated traders' trading strategies in the market. However, conducting earnings management generates disutility to the manager. This paper proves analytically that tightening accounting standards leads to a lower variability and higher value relevance of the reported earnings. This paper also proves that tightening accounting standards decreases the level of the expected earnings management. These results can be very useful to standard setters in considering tightening accounting standards.