The optimal stringency of accounting regulation to alleviate time inconsistency problems

Abstract

Although accounting regulation restricts the use of accrual-based earnings management (AEM) to discourage firms from directly distorting accounting numbers, firms can substitute real earnings management (REM), which distorts real operations, to change accounting numbers. Consequently, recent research has emphasized that accounting regulation might be ineffective or even detrimental. However, this paper shows that the time inconsistency of AEM is more serious than that of REM and thereby results in a threshold below which accounting regulation can reduce AEM without inducing REM. The threshold coincides with the optimal stringency of accounting regulation to minimize the managerial inefficiencies caused by time inconsistency.