The Effects of Limiting Accounting Discretion on the Informativeness of Financial Statements: Evidence from Software Revenue Recognition

Abstract

This paper examines the effects on the informativeness of software companies' financial statements of limiting the amount of discretion with respect to software revenue recognition following the issuance of Statement of Position 91-1 in 1992. The requirement that companies adopt SOP 91-1 by restating earnings for prior periods allows to compare the value-relevance of two sets of data, the originally reported and the restated earnings numbers. I find that the originally reported numbers provide incremental information content over the more conservative restated earnings numbers. This finding is consistent with managers using their discretion in pre-SOP 91-1 periods to convey private information about their firms' underlying economics. Furthermore, relative to a control group of software firms less sensitive to the accounting change, I document a significant decline in the information content of sample firms' reported earnings following the issuance of SOP 91-1, as well as a significant increase in the voluntary disclosure of long-term earnings projections and non-financial information. I interpret these findings as evidence that limiting the amount of discretion has adversely affected managers' ability to communicate effectively with investors through the financial statements.