Accounting Standards, Earnings Management, and Earnings Quality

Abstract

This paper examines how the characteristics of accounting systems and management incentives interact and collectively determine financial reporting quality. We develop a rational expectations equilibrium model that features a steady-state firm with investments, financial and non-financial information, and earnings management opportunities. We measure earnings quality by the information content of earnings in equilibrium. The analysis confirms some intuitive results, such as that earnings quality increases in accounting precision. However, we also find counter-intuitive results, such as that an accounting standard that makes unbiased accounting earnings more informative can reduce earnings quality. These results are mainly driven by an interaction between managers’ smoothing incentives and smoothing provided by the accounting standard. Finally, we study value relevance measures and show that they trace the changes in earnings quality accurately for the variation of some and not of other characteristics of the accounting system.

Keywords: earnings quality, earnings management, accounting standards, value relevance, earnings response coefficient

JEL Classification: D80, G12, G14, M41, M43