Rules-based vs. Principles-based Accounting Standards: Earnings Quality and the Role of Earnings in Contracting (An Analysis employing the adoption of ASC 606)

60 Pages Posted: 13 Feb 2020 Last revised: 21 Jul 2020

See all articles by Kyungran Lee

Kyungran Lee

The University of Hong Kong - School of Business

ShinWoo Lee

Columbia University - Columbia Business School

Date Written: July 20, 2020

Abstract

We examine the effect of the adoption of the new revenue recognition standard (ASC 606) on earnings quality and the role of earnings in the debt market. We find that ASC 606, a transition from a rules-based to a principles-based accounting standard, decreases earnings predictability, which is demonstrated by increased absolute analyst forecast error and analyst forecast dispersion, and increases the use of discretion in preparing earnings numbers, which is demonstrated by increased discretionary accruals. In addition, the use of earnings-based covenants decreases in debt contracting, while the use of capital-based covenants increases, which indicates a decrease in the usefulness of earnings numbers in contracting. In terms of the stock market response, overall, the earnings response coefficient (ERC) does not change after the new rule. However, following the adoption, the ERC has increased for firms with high institutional holdings and decreased for firms with low institutional holdings. Our analysis supports the idea that this is due to monitoring from institutional investors curbing the use of discretionary accruals.

Keywords: ASC 606, principles-based accounting standard, rules-based accounting standard, earnings quality, debt covenant, analyst forecasts, institutional investors

JEL Classification: G18, M41, M48

Suggested Citation

Lee, Kyungran and Lee, Shin Woo, Rules-based vs. Principles-based Accounting Standards: Earnings Quality and the Role of Earnings in Contracting (An Analysis employing the adoption of ASC 606) (July 20, 2020). Available at SSRN: https://ssrn.com/abstract=3534039 or http://dx.doi.org/10.2139/ssrn.3534039

Kyungran Lee (Contact Author)

The University of Hong Kong - School of Business ( email )

Meng Wah Complex
Pokfulam Road
Hong Kong
China

Shin Woo Lee

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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