Rules‐ vs. Principles‐based Accounting Standard: Earnings Quality and the Role of Earnings in Contracting (An Analysis Employing the Adoption of ASC 606)

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.

The ASC 606 standard, revenue informativeness, and analysts forecast quality

“…Second, we compare the post‐adoption period's revenue informativeness between firms in industries heavily affected by ASC 606 and those in less affected industries. Lee and Lee (2020) suggest that the top five industry groups (based on Fama–French's 49 industry classification) most affected by ASC 606 include computer software, followed by pharmaceutical products, trading, retail, and electronic equipment. We use Lee and Lee's (2020) top five industry groups to identify industries that are more or less affected by ASC 606.…”

“…A recent study of SEC comment letters regarding ASC 606 adoption suggests that several companies have issues with the disclosure of accounting positions taken under the new standard, despite extensive guidance from the FASB (Deloitte, 2019). Researchers have expressed concerns that the principle‐based nature of ASC 606 may increase discretion in the revenue recognition process (Lee & Lee, 2020). Additionally, Herz (2003) shows that principle‐based standards may introduce more discretion as managers have more room for interpretation.…”

“…Analysts' forecast dispersion could be greater and forecast errors could be larger in the post‐adoption period. Additionally, the principle‐based nature of the new standard may create opportunities for management to use discretion in revenue reporting (Lee & Lee, 2020). This may deteriorate the consensus and accuracy of financial analysts' forecasts.…”

“…Ferreira (2020) and Chung and Chuwonganant (2020) find that ASC 606 positively impacts trading activities, that is, it improves market liquidity, information asymmetry, and pricing efficiency. Furthermore, Lee and Lee (2020) highlight that the new standard has a negative effect on earnings predictability but does not affect earnings response coefficients. Our study has a certain overlap with Lee and Lee (2020) but differs in several ways.…”

“…Furthermore, Lee and Lee (2020) highlight that the new standard has a negative effect on earnings predictability but does not affect earnings response coefficients. Our study has a certain overlap with Lee and Lee (2020) but differs in several ways. First, while Lee and Lee (2020) analyse the change in perceived earnings quality, we focus on the change in perceived revenue informativeness.…”