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Principles-Based Accounting Standards, Earnings Management and Price Efficiency

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  • Michael Ehud Yampuler

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.Â

Suggested Citation

  • Michael Ehud Yampuler, 2019. "Principles-Based Accounting Standards, Earnings Management and Price Efficiency," Accounting and Finance Research, Sciedu Press, vol. 8(2), pages 171-171, May.
  • Handle: RePEc:jfr:afr111:v:8:y:2019:i:2:p:171
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    References listed on IDEAS

    as
    1. Michael J. Fishman & Kathleen M. Hagerty, 1989. "Disclosure Decisions by Firms and the Competition for Price Efficiency," Journal of Finance, American Finance Association, vol. 44(3), pages 633-646, July.
    2. repec:bla:jfinan:v:44:y:1989:i:3:p:633-46 is not listed on IDEAS
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    JEL classification:

    • R00 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General - - - General
    • Z0 - Other Special Topics - - General

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