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
Date Written: July 20, 2020
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: Suggested Citation