Principles vs. Rules and the Information Environment: The Case of SFAS 95

Abstract

We provide evidence on the “principles vs. rules” standards debate by examining how changes in cash flow reporting methods required by SFAS 95 Statement of Cash Flows affected firms’ information environments. We argue that adoption of SFAS 95 represented a change from a principle based standard (APB 19) to a rules based standard. Using a difference-in-difference research design, we find for firms required to adopt its provisions (mandatory switchers), SFAS 95 resulted in a deterioration in their information environments, as evidenced by increases in bid-ask spreads and stock return synchronicity as well as decreases in trading volume and analyst coverage. Firms with richer information environments exhibit a mitigated response. Information environments deteriorated more when cash flow information is arguably more important. In addition, the evidence does not indicate the deterioration is mitigated when firms are in industries that experienced greater increases in industry reporting conformity. Together, these findings are consistent with firms, on average, using their reporting discretion to convey private information to investors.

Keywords: rules-based accounting standards, principles-based accounting standards, information environment, SFAS 95 Statement of Cash Flows

JEL Classification: M40, M41