Rule- vs. Principle-Based Accounting Standard and Earnings Characteristics : An Analysis Using ASC 606
51 Pages Posted: 13 Feb 2020
Date Written: February 6, 2020
We examine the effect of the adoption of the new revenue recognition standard (ASC 606) on earnings characteristics and how it, in turn, affects the stock and the debt market. The new rule standardizes, simplifies, and harmonizes previous revenue recognition practices among companies, which is a transition from a rule-based accounting standard to a principle-based accounting standard. We find that the new rule decreases earnings predictability and it is associated with the increased discretion in preparing earnings numbers. In addition, the use of earnings-based covenants decreases in debt contracting. However, we do not find evidence that the new standard is associated with an increase in earnings management behavior. In terms of the stock market response, the earnings response coefficient (ERC) does not change after the new rule overall. However, it has increased for firms with high institutional holdings after the adoption and decreased for firms with low institutional holdings. Our analysis supports the idea that this is due to different investors interpreting the new disclosure associated with ASC 606 differently.
Keywords: ASC 606, principle-based accounting standard, rule-based accounting standard, earnings characteristics, debt covenant, institutional investors
JEL Classification: G18, M41, M48
Suggested Citation: Suggested Citation