Journal of Applied Accounting Research

The impact of principles-based vs rules-based accounting standards on reporting

quality and earnings management
Dennis Sundvik,
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Dennis Sundvik, (2019) "The impact of principles-based vs rules-based accounting standards on
reporting quality and earnings management", Journal of Applied Accounting Research, Vol. 20 Issue:
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JAAR
20,1 The impact of principles-based vs
rules-based accounting standards
on reporting quality and
78 earnings management
Received 9 May 2018
Revised 14 August 2018
Dennis Sundvik
19 October 2018 Hanken School of Economics, Helsinki, Finland
Accepted 28 November 2018

Abstract
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Purpose – The purpose of this paper is to explore whether principles-based vs rules-based accounting
standards have an effect on measures of financial reporting quality and earnings management strategies.
Design/methodology/approach – This study uses a firm-year-specific variable that captures the extent to
which firms’ accounting and operating behavior is affected by the characteristics of a specific standard in the
USA. Measures of absolute accruals, financial misconducts, signed abnormal accruals and abnormal cash
flows are used to assess the effects.
Findings – The results show that absolute magnitude of accruals and probability of financial misconduct is
lower, and accrual earnings management is higher when firms’ standards are more based on principles. The
study also suggests that potentially costlier real earnings management is a consequence of rules-based standards.
Research limitations/implications – This study relies heavily on measures from the prior accounting
literature, hence, care has been exercised in generalizing the findings.
Practical implications – This study has direct implications for a number of stakeholders, including standard
setters, policymakers, securities regulators, researchers, investors, financial statement preparers and auditors.
For example, the future development of accounting standards can be supported by the empirical conclusions in
this study together with previous standard-setting ambitions, commentaries, experiments and analytical work.
Originality/value – This study extends prior single-country studies on reporting quality and cross-country
studies on transition effects of firms switching from local to International Accounting Standards by
observing the impact of accounting standard characteristics on additional measures of reporting quality and
accrual as well as real earnings management when holding institutional factors constant. The study also
offers archival evidence complementing prior commentaries, experiments and analytical work.
Keywords Earnings management, Accounting standards, Accruals, Principles-based standards
Paper type Research paper

1. Introduction
Since the major accounting scandals (e.g. Enron and WorldCom) that eventually led to the
Sarbanes–Oxley Act (SOX) in 2002, the potential benefits and costs of accounting standard
characteristics and whether the USA should move to a more principles-based system have been
debated. An argument is that transaction structuring played a big role in the scandals and that
the rules-based characteristics of the US Generally Accepted Accounting Principles (GAAP)
were to blame. Through financial engineering, firms were able to achieve technical compliance
while evading the actual intent. More principles-based standards, like the International
Financial Reporting Standards (IFRS) that European publicly listed firms apply, provide more
discretion for managers, which, in turn, allow them to better capture the underlying business
economics while simultaneously complying with the intent. As a response to the critics, the US
standard-setting bodies have pushed for a move toward more principles-based standards and
considered a potential adoption of IFRS to increase reporting quality.
Journal of Applied Accounting
Research The author would like to thank the journal Editor, two anonymous journal referees, Josué Braga, Jesper
Vol. 20 No. 1, 2019
pp. 78-93 Haga and Dan Givoly for their insightful comments that have greatly benefitted the paper. The author is
© Emerald Publishing Limited also grateful for the financial support from the Foundation for Economic Education (Liikesivistysrahasto),
0967-5426
DOI 10.1108/JAAR-05-2018-0063 Society of Swedish Literature in Finland and Suomen Arvopaperimarkkinoiden Edistämissäätiö.
 Empirical evidence indicates that principles-based standards lead to higher reporting quality Reporting
together with an increase in accrual earnings management (Folsom et al., 2017). While Schipper quality and
(2003) comments on the positive attributes of rules-based standards, she reasons that earnings
rules-based standards force firms to substitute accrual earnings management with real earnings
management. Specifically, due to less discretion, rules-based standards constrain the use of management
accruals and lead to potentially costlier manipulation of cash flows when there is pressure to
perform. The model of Ewert and Wagenhofer (2005) consistently shows that real earnings 79
management increases with rules-based standards. However, researchers have not fully
examined whether these arguments hold with archival data. Besides examining the relation
between various measures of reporting quality and accounting standard characteristics, I aim to
fill this empirical void in the literature. Studying real earnings management is important due to
its potential damaging effects on firms’ future value and based on the aggregate effects on the
economy as a whole (Vorst, 2016; Bereskin et al., 2018). As such, this paper answers the call of
Nelson (2003) for more research on the implications of accounting standard characteristics, and
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the call of DeFond (2010) and Walker (2013) for more real earnings management research
overall and specifically for more insight into the real earnings management implications of
accounting standards.
Following Folsom et al. (2017), I use a firm-year-specific measure that captures the extent to
which the US firms’ accounting is affected by the characteristics of a specific standard. I provide
evidence that principles-based standards are associated with lower absolute total and abnormal
accruals, and a lower incidence of financial misconduct. In terms of earnings management, I find
that firms with greater reliance on principles-based standards engage in more accrual and less
real earnings management. Considering that prior research (e.g. Vorst, 2016; Bereskin et al.,
2018) identifies real earnings management as more costly in the long-run, rules-based standards
could potentially have more negative consequences than principles-based standards.
In Folsom et al. (2017), the focus is on the relevance and decision usefulness of financial
statements depending on the reliance on principles-based standards. Other studies using the
similar measure concentrate on the US Securities and Exchange Commission (SEC) comment
letters (Boone et al., 2013) and determinants of rules-based characteristics (Donelson et al., 2016).
I extend these studies by examining how accounting standards shape reporting quality in
general and earnings management strategies in particular. By investigating accrual and real
earnings management and showing how accounting standards determine the choice of
earnings management strategy beyond firm-level costs such as financial health or audit
quality, I contribute to the trade-off literature on earnings management (Zang, 2012; Haga et al.,
2018). My results based on archival data also complement and test the arguments and models
of prior commentaries, experiments and analytical work (Nelson et al., 2002; Nelson, 2003;
Schipper, 2003; Ewert and Wagenhofer, 2005). Combining these provides a solid ground for
future discussions of the real consequences of accounting standard characteristics. Previous
archival research (e.g. Barth et al., 2008) primarily investigates cross-country transition effects
of firms switching from local GAAP to IFRS. Due to variations in institutional settings and
problems with voluntary adopters, such studies face several challenges (Gordon et al., 2013).
I overcome many problems by focusing on a large sample from the largest economy in the
world and utilizing the variation within one set of domestic standards, namely, the US GAAP.
The paper proceeds as follows. Section 2 reviews the literature and develops hypotheses.
Section 3 describes the research methods. Section 4 presents the results. The final section
concludes.

2. Prior literature and hypotheses development

2.1 Theoretical foundations of reporting quality and earnings management
While better reporting quality generally means that firms provide better information about
its financial performance, the definition of reporting quality largely depends on the decision
 JAAR context (Dechow et al., 2010). Meanwhile, Walker (2013) notes that earnings management
20,1 mostly is a reporting quality decreasing factor and defines earnings management as
instances where managers use their discretion over accounting choices, reporting choices
and real business decisions with the ultimate goal of influencing how underlying events are
reflected in various measures of earnings. In general, accounting studies explain variations
in reporting quality and earnings management with agency theory ( Jensen and Meckling,
80 1976), which suggests that earnings management and reduced reporting quality is an
artifact of conflicts of interest and information asymmetries between managers and other
stakeholders arising from the various contracts existing in a firm. For instance, managers
are likely to have both easy access to information relevant for predicting future cash flows,
discretion over reported numbers, and incentives to meet or beat various expectations due to
reward contracts. Simultaneously, it is hard for external investors to evaluate managers.
Thus, managers may act opportunistically to maximize their compensation (Watts and
Zimmermann, 1986). At the same time, investors may benefit from the fact that managers
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have reporting discretion, since managers can use it to communicate value relevant private
information about future cash flows. As such, managers can both improve reporting quality
by information signaling and reduce it by earnings management.

2.2 Accounting standard characteristics and reporting quality

An accounting standard is the total body of principles and rules that apply to a given accounting
issue (Nelson, 2003). While the US GAAP are commonly regarded as rules-based due to the
characteristics of many bright-line rules, examples, scope restrictions, exceptions, subsequent
precedents, implementation guidance, etc. there is of course also a great deal of variation within
the standard, both across time and across individual standards. For example, the lease
standard Statement of Financial Accounting Standards (SFAS) 13 has many bright-line rule
characteristics whereas the SFAS 5 (Accounting for Contingencies) is less amenable to rules or
thresholds, and thus more principles-based. These differences within US GAAP allow for a
meaningful investigation into implications of accounting standard characteristics.
Several empirical studies suggest that reporting quality is affected by accounting standard
characteristics. More principles-based standards could increase reporting quality because
managers with more financial reporting degrees of freedom can use the discretion to
create higher-quality information. More discretion also allows managers to better accommodate
the specifics of a certain business transaction in the financial reporting. In contrast, more
rules-based accounting standards could force managers to report in a certain way based on a
bright-line rule, inducing noise in the financials due to a bad fit with the economic transaction
(Dye and Sunder, 2001). Consistent with this reasoning, Subramanyam (1996) investigates the
pricing of accruals and finds that managerial discretion improves the ability of earnings to
reflect economic transactions. When revenue recognition flexibility is limited by rules,
Srivastava (2014) suggests that reporting quality is reduced. Dichev et al. (2013) find that fewer
rules in standards also increase the perceived reporting quality. With respect to the amount of
accounting restatements, Peterson (2012) finds that the complexity of rules-based revenue
recognition standards results in lower reporting quality. Similarly, Boone et al. (2013) provide
evidence that rules-based characteristics increase the likelihood of SEC review comments, due to
questionable accounting.
Observing other aspects of reporting quality such as the degree of income smoothing, loss
avoidance, timely loss recognition and value relevance of accounting numbers, Barth et al.
(2008) study voluntary adopters of International Accounting Standards (IAS) from
21 countries. Here, IAS is considered more principles-based than previously applied local
GAAP standards. They find increased reporting quality (e.g. less income smoothing) after IAS
implementation. This finding is consistent with the analytical modeling of Ewert and
Wagenhofer (2005) indicating that principles-based standards result in higher-quality
 earnings that are more reflexive of a firm’s underlying economics. This work is also consistent Reporting
with Folsom et al. (2017) that use a firm-specific measure of accounting standard quality and
characteristics in the USA, and find a positive association between principles-based standards earnings
and three attributes of quality.
The current study extends the prior literature by investigating other proxies of reporting management
quality from Dechow et al. (2010) that have not been used in a broad sample of firms. The
first hypothesis of the study states that more principles-based standards are positively 81
associated with reporting quality:
H1. Reporting quality is higher for firms with more principles-based accounting standards
than for firms with more rules-based accounting standards.
While the extant literature suggests that principles-based standards are associated with
higher reporting quality, I could also find contradicting results if the added discretion
generates more opportunistic use of accounting numbers. Namely, several studies (e.g. Nelson
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et al., 2002; Folsom et al., 2017) find that managers engage in accrual earnings management
when standards are based on principles. One underlying reason is that auditors and other
gatekeepers have a hard time to prove that various discretionary judgments are incorrect.
However, the increase in accrual earnings management should be most prominent in settings
where there are clear incentives ( for a review of such incentives, see Walker, 2013). Thus, the
prediction of H1 should still hold in a general context. The next section provides a deeper
discussion on earnings management.

2.3 Accounting standard implications for accrual and real earnings management
Much of the prior literature on earnings management is involved with accrual earnings
management, which deals with the various accounting choices managers can make in order
to reach various reporting objectives without affecting cash flows (Walker, 2013). However,
since Graham et al. (2005) indicated that managers are not afraid to sacrifice long-term value
for short-term gains by altering cash flows either, the literature increasingly analyses real
earnings management. One example of real earnings management is sales manipulation,
which may take the form of more lenient credit terms or offering price discounts in order to
temporarily increase sales and consequently, earnings. This will cause lower current-period
abnormal cash flows from operations but likely also lower cash flows in the future since
customers will continue to demand similar credit terms or price discounts (Roychowdhury,
2006). Firms not able to satisfy these customers could thus face future customer losses and
decreasing sales. Vorst (2016) and Bereskin et al. (2018) portray similar evidence of the
value-destroying consequences of real earnings management. Thus, differentiating between
the strategies of earnings management is highly important.
Zang (2012) recognizes that there is a trade-off between the different earnings
management strategies so that firms with high costs for real earnings management engage
in more accrual earnings management, and vice versa. For example, since real earnings
management sacrifices long-term value, firms in poorer financial health engage in more
accrual earnings management. Using this framework, I expect a trade-off between different
earnings management strategies based on the reliance on principles-based or rules-based
accounting standards. This expectation is mainly built on analytical work by Demski (2004)
and Ewert and Wagenhofer (2005). Demski (2004) assumes that rules-based standards
reduce accrual earnings management. Furthermore, Ewert and Wagenhofer (2005), based on
Fisher and Verrecchia (2000), make a case for a trade-off story by suggesting that more
rules-based standards restrict the possibility for accrual earnings management while such
characteristics actually increase costly real earnings management. Both commentaries of
Nelson (2003) and Schipper (2003) subsequently indicate that rules-based accounting
standards should increase earnings management through real activities and transaction
 JAAR structuring that has cash flow effects. However, this has not been empirically tested with
20,1 archival data. The current study will fill this void in the literature.
Prior empirical work on the characteristics of accounting standards has mainly focused on
earnings management in general or accrual earnings management. In a cross-country study,
Barth et al. (2008) view income smoothing as earnings management and find less with more
principles-based standards (after the voluntary adoption of IAS/IFRS). Christensen et al. (2015)
82 find the same in Germany. For mandatory IFRS adopters, Ahmed et al. (2013) and Christensen
et al. (2015) show that smoothing has increased. With a focus on both voluntary and
mandatory IFRS adopters, Capkun et al. (2016) find that income smoothing increased for all.
Similarly, Callao and Jarne (2010) suggest that IFRS led to more abnormal accruals.
Jeanjean and Stolowy (2008) examine earnings distributions around IFRS implementation in
three countries, but only find an increase in earnings management post-adoption in France,
suggesting that principles-based standards could be associated with more earnings management
in general. Barth et al. (2008) do not find the frequency of small positive profits to be significantly
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different in different regimes. The result of Jeanjean and Stolowy (2008) is, however, partly
consistent with the findings of Folsom et al. (2017) who find a higher kink in the earnings
distribution around zero for principles-based firms than for rules-based firms. Neither of these
studies discriminate between accrual and real earnings management, which means that their
findings relating to earnings benchmarks could be driven by either of the two strategies, or by
both, or simply suggesting that accrual earnings management is a more precise earnings
management tool, and therefore more strongly associated with benchmarks. In contrast, Ipino
and Parbonetti (2017) show that mandatory IFRS adoption in countries with strong enforcement
regimes has led to a decrease in accrual earnings management and an increase in costly real
earnings management. Walker (2013) recognizes the negative consequences of real earnings
management and calls for more research. Meanwhile, Doukakis (2014) does not find any
significant support for increased accrual or real earnings management after IFRS adoption, in
unsigned (absolute) terms where the direction of earnings management is not considered. The
current study analyses the direction of earnings management using the variation of accounting
standard characteristics within the US GAAP. Based on the majority of the literature, I formulate
two hypotheses regarding accrual and real earnings management, respectively, as follows:
H2. Accrual earnings management is higher for firms with more principles-based
accounting standards than for firms with more rules-based accounting standards.
H3. Real earnings management is lower for firms with more principles-based accounting
standards than for firms with more rules-based accounting standards.

3. Research methods
3.1 Variables and empirical models
I obtain data from the Compustat North America Annual file for the bulk of the dependent
variables and controls; the US Government Accountability Office (GAO) restatements
from Hennes et al. (2008)[1]; SEC Accounting and Auditing Enforcement Releases
(AAERs) from Dechow et al. (2011) and Center for Financial Reporting and Management at
UC Berkeley; and from Folsom et al. (2017) to measure the extent to which US publicly
listed firms rely upon more principles-based standards[2]. Specifically, I use the firm-year
PSCORE measure from Folsom et al. (2017) as the independent variable of main interest.
This measure is available for the years 1994–2006 and measures the extent to which the
US publicly listed firms rely upon more principles-based standards, or less rules-based
characteristics. The measure considers the accounting standard characteristics based on
keyword searches and measures the impact of each specific standard on a firm.
The standardized firm-year-specific measure capturing the standard orientation of a firm
 is constructed as the combination of standards a firm applies. Higher values of PSCORE Reporting
indicate a higher reliance on principles-based standards. For ease of interpretation, quality and
I use the quintiles of the PSCORE variable to examine how cross-sectional variation in earnings
reliance on different accounting standards is associated with the dependent variables.
The measure has been thoroughly validated by its creators and applied in some form by, management
for example, Boone et al. (2013) and Donelson et al. (2016).
With regard to the dependent variables, I use proxies for reporting quality in different 83
forms to test H1. I first use the magnitude of total accruals (TACC) and abnormal accruals
(AACC). Consistent with Dechow et al. (2010), higher absolute accruals are lower quality
because they represent a less persistent component of earnings. I calculate TACC as earnings
less operating cash flows. I obtain AACC by separating them from normal accruals using the
procedure in Kothari et al. (2005) where TACC is explained by the reciprocal of lagged total
assets, change in sales (SALE), property, plant and equipment (PPE) and lagged performance
(IB) with the following regression model:
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TACCi;t ¼ b1 1=ATi;t1 þb2 DSALEi;t þb3 PPEi;t þb4 IBi;t1 þei;t : (1)
All variables are scaled by lagged total assets (AT). The regression model is estimated for
every two-digit industry code and year with at least 15 observations per industry year. The
residuals (ε) obtained from the regressions of Equation (1) are equal to AACC. Using
absolute TACC or AACC as the proxy for reporting quality, I test H1 by estimating the
following regression:



jTACCji;t or jAACCji;t ¼ a0 þ b1 PSCOREi;t þb2 SIZEi;t




þ b3 ROEi;t þb4 LOSSi;t þb5 SDROAi;t




þ b6 LEVi;t þb7 GROWTHi;t þb8 OPCYCLEi;t



þb9 INVi;t þb10 BIG4i;t þIndustry=Year Fixed Effectsþ ei;t : (2)
If higher reliance on principles-based standards is associated with higher reporting
quality (lower |TACC| or |AACC|), the coefficient on PSCORE will be negative. Besides the
variable of interest, I add a number of control variables. First, I add SIZE (the natural
logarithm of total assets) because it may be a surrogate for various omitted variables
(Ashbaugh-Skaife et al., 2008; Hope et al., 2013; Höglund and Sundvik, 2016). Second,
I include return on equity (ROE), cumulative number of loss-years (LOSS) and standard
deviation of return of assets for at least three fiscal years (SDROA) as controls for
performance and volatility since firms facing distress are likely to report with lower
quality (Kothari et al., 2005; Hope et al., 2013). Third, I add LEV (debt to assets) because
highly leveraged firms and firms close to violating their debt covenants may also have
lower quality earnings due to stronger earnings management incentives (DeFond and
Jiambalvo, 1994; Zang, 2012). Fourth, Ashbaugh-Skaife et al. (2008) note that rapidly
growing firms are likely to have more noise in the reporting quality measures due to
anticipation of future sales growth and I therefore include GROWTH (growth in assets).
Following Dechow and Dichev (2002), I add controls for operating cycle (OPCYCLE)
and inventory (INV ), since reporting quality is likely related to operating cycle length and
variability of operations. I also include an indicator variable for audit quality (BIG4) based
on the reasoning that larger auditors provide a better foundation for the quality of
financial information (Hope et al., 2013). Finally, I add industry and year fixed effects.
As a second set of proxies for reporting quality, I use the GAO and SEC AAER financial
misconduct data sets. These external indicators of reporting quality have an advantage over
accruals in the sense that outsiders have identified a problem with quality ex post. Using the
two forms, I capture different nuances of reporting quality since GAO restatements include
 JAAR both accounting irregularities and accounting estimation errors whereas AAERs tend to
20,1 be more fraudulent. I expect firms with a higher reliance on principles-based standards to
have a lower probability of GAO restatements and AAERs. To test H1 using these
measures, I estimate the following logistic regression model:

1

Prob GAOi;t or AAERi;t ¼ Z
; where Z ¼ a0 þb1 PSCOREi;t
1 þe
84



þb2 SIZEi;t þb3 ROEi;t þb4 LOSSi;t




þb5 SDROAi;t þb6 LEVi;t þb7 GROWTHi;t




þb8 OPCYCLEi;t þb9 INVi;t þb10 BIG4i;t
þIndustry=Year Fixed Effects þei;t : (3)
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If higher reliance on principles-based standards is associated with higher reporting quality

(lower probability of financial misconduct), the coefficient on PSCORE will be negative.
The model includes the same control variables as in Equation (2).
For tests of H2 and H3, I differentiate accrual from real earnings management. In terms of
accrual earnings management, I observe the direction and use the signed AACC as a proxy
where higher values are more income increasing. For real earnings management, I estimate
abnormal cash flows from operations (ACFO) using the procedure in prior research
(Roychowdhury, 2006; Haga et al., 2018). Accordingly, the reciprocal of lagged total assets,
contemporaneous sales, and change in sales explain cash flows from operations (CFO) in the
following regression model:




CFOi;t ¼ a0 þb1 1=ATi;t1 þb2 SALEi;t þb3 DSALEi;t þei;t : (4)
I scale all variables by lagged total assets and estimate the regression model for every two-digit
industry and year with at least 15 observations. The residuals (ε) from Equation (4), multiplied
by −1 for ease of interpretation, are the ACFO. Higher values are more income increasing.
To formally test H2 and H3, I estimate the following fixed-effects regression:




AACCi;t or ACFOi;t ¼ a0 þb1 PSCOREi;t þb2 SIZEi;t þb3 ROEi;t





þb4 LOSSi;t þb5 SDROAi;t þb6 LEVi;t þb7 GROWTHi;t




þb8 OPCYCLEi;t þb9 INVi;t þ b10 BIG4i;t


þb11 ACFOi;t or AACCi;t þIndustry=Year Fixed Effectsþei;t ; (5)
where the dependent variable is signed (positive or negative) accrual earnings management (H2)
or real earnings management (H3). The control variables remain the same with the addition of
ACFO (AACC) when AACC (ACFO) is the dependent variable following Haga et al. (2018). For
H2 and AACC as the dependent variable, if higher reliance on principles-based standards is
associated with more accrual earnings management, the coefficient on PSCORE will be positive.
For H3 and ACFO as the dependent variable, if higher reliance on principles-based standards is
associated with less real earnings management, the coefficient on PSCORE will be negative.
To mitigate the influence of outliers in the continuous variables, I winsorize them all at the top
and bottom 1 percent.

3.2 Sample and descriptive statistics

The sample encompasses the time period from 1994 to 2006, based on the availability of the
PSCORE measure. I begin with the full sample of Folsom et al. (2017) comprising 41,022
firm-years. After deducting firm-years with missing data for the dependent and control
 variables, I end up with 27,498 firm-years for tests excluding earnings management and Reporting
27,110 including earnings management (due to more stringent data requirements). Panel A quality and
of Table I reports descriptive statistics. On average, absolute total accruals are larger than earnings
absolute abnormal accruals. In (untabulated) analyses, signed total accruals are negative,
indicating that depreciation drives the aggregate downward. Within the sample, there are management
more GAO than AAER observations. Accrual earnings management is, on average, more
income increasing than real earnings management. The size of the sample firms indicates 85
that the formation is not very different from the sample of Folsom et al. (2017). As expected,
most firms also employ a large auditor (Zang, 2012).
In Panel B of Table I, I partition the sample by the most extreme quintiles of PSCORE and
examine the dependent variables separately. Firms in the highest quintile of PSCORE
have lower absolute total accruals, a lower amount of GAO observations and lower AAERs
than firms in the lowest quintile of PSCORE, suggesting that reporting quality is higher when
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accounting standards are more principles-based. However, the absolute value of abnormal
accruals is larger in the highest quintile of PSCORE, potentially due to more accrual earnings
management. The positive average of abnormal accruals in high PSCORE firms also suggests
that there is more income increasing accrual earnings management in these firms. Meanwhile,
the abnormal cash flows from operations show the opposite signs, suggesting that there is
more real earnings management in the rules-oriented firms. This would be consistent with the
trade-off expectations. See Panel C of Table I for variable definitions.
Table II reports that higher reliance on principles-based standards is positively
correlated with reporting quality in the form of lower absolute total accruals and lower
incidence of financial misconduct. Consistent with the analysis in Panel B of Table I, |AACC|
is positively correlated with PSCORE. Furthermore, PSCORE is negatively correlated with
ACFO. Consistent with Zang (2012), there is a positive correlation between the earnings
management proxies. Overall, the correlations in Table II are not strong enough to infer bias
in the regression models. In addition, the Variance Inflation Factors for the variables are all
below 4.0, which mitigates multicollinearity concerns.

4. Results
4.1 Accounting standards and reporting quality
Table III presents the regression results of Equation (2) in Models (1) and (2), and of Equation
(3) in Models (3) and (4). Using both approaches, the regressions associate principles-based
standards with higher reporting quality. Namely, the coefficient on the quintile rank value of
PSCORE is negative and statistically significant in all four models[3]. This result is consistent
with H1. Holding other variables constant, the Model (1) results suggest that moving from the
lowest to the highest quintile of PSCORE decreases the absolute value of total accruals of the
average firm by 0.012. Furthermore, firms that are more profitable and with higher audit
quality have higher reporting quality. Growing firms, however, contribute to lower reporting
quality. The signs and levels of significance of these variables are consistent with the findings
of prior studies (e.g. Hope et al., 2013). The explanatory power is above 20.0 percent in both
Models (1) and (2), which is relatively good with aggregate accrual dependent variables. The
results, in Models (3) and (4) of Table III, confirm a significantly negative relation between
PSCORE and financial misconduct in the multivariate setting[4]. The more principles-based
standards, the less likely the firm is to restate or have an accounting irregularity. Considering
the coefficient of −0.196 on PSCORE in Model (3), a change in the quintile of PSCORE from
highest to lowest leads to a large increase in the probability of financial misconduct from 0.016
to 0.035, holding other variables fixed. The explanatory power of the models is satisfactory
and explains 8.5 percent of the dependent variables, on average. With regard to the control
variables, larger firms and firms with more losses have more restatements.
 JAAR Panel A: descriptive statistics for the full sample
20,1 Variable Mean Median SD 25% 75% n
Raw PSCORE −15.757 −13.821 9.460 −19.359 −9.849 27,498
|TACC| 0.094 0.064 0.142 0.032 0.113 27,498
|AACC| 0.069 0.043 0.077 0.019 0.089 27,110
GAO 0.062 0.000 0.241 0.000 0.000 27,498
AAER 0.014 0.000 0.117 0.000 0.000 27,498
86 AACC 0.004 0.005 0.104 −0.038 0.049 27,110
ACFO −0.003 −0.005 0.130 −0.066 0.052 27,110
SIZE 5.758 5.612 1.929 4.318 7.031 27,498
ROE 0.007 0.094 0.804 −0.006 0.159 27,498
LOSS 0.247 0.000 0.349 0.000 0.429 27,498
SDROA 0.072 0.029 0.166 0.012 0.071 27,498
LEV 0.496 0.493 0.265 0.300 0.655 27,498
GROWTH 0.185 0.071 0.605 −0.020 0.213 27,498
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OPCYCLE −3.049 −3.298 0.968 −3.680 −2.651 27,498

INV 0.152 0.120 0.137 0.040 0.221 27,498
BIG4 0.893 1.000 0.309 1.000 1.000 27,498
Panel B: reporting quality and earnings management variables by PSCORE
Lowest quintile of Highest quintile of
PSCORE PSCORE
Variable Mean Median Mean Median Diff. Mean Diff. Median
|TACC| 0.095 0.062 0.091 0.064 ***
|AACC| 0.060 0.037 0.072 0.047 *** ***
GAO 0.102 0.000 0.038 0.000 *** ***
AAER 0.023 0.000 0.007 0.000 *** ***
AACC −0.004 0.002 0.011 0.009 *** ***
ACFO 0.005 0.001 −0.019 −0.019 *** ***
Panel C: variable definitions
Variable Definition
PSCORE The quintile rank value of raw PSCORE which is the reliance on principles-based accounting
standards from Folsom et al. (2017)
TACC Total accruals, earnings (IB) – operating cash flows (CFO) scaled by lagged total assets (AT)
AACC Abnormal accruals, estimated as the residual of Equation (1)
GAO An indicator variable that is equal to 1 if the firm is included in the GAO data set, and 0 otherwise
AAER An indicator variable that is equal to 1 if the firm is included in the AAER data set, and 0
otherwise
ACFO Abnormal cash flows from operation, estimated as the residual of Equation (4), multiplied by −1
SIZE Natural logarithm of total assets (AT)
ROE Return on equity, defined as earnings (IB) divided by average total equity (CEQ)
LOSS Cumulative percentage of sample years that the firm reported a loss (negative IB)
SDROA Standard deviation of return on assets (IB/AT), measured at the firm level over the sample
period for firms with at least three annual observations
LEV Leverage, measured as total liabilities (LT) divided by total assets (AT)
GROWTH Growth in total assets (AT) in the current year compared with the previous year
OPCYCLE Natural logarithm of the length of the firm’s operating cycle, defined as sales turnover plus
days in inventory [(SALE/360)/(average RCT) + (COGS/360/(average INVT)] and is averaged
over at least three annual observations
INV Inventory (INVT) divided by total assets (AT)
BIG4 An indicator variable that is equal to 1 if the firm employs a BIG4 auditor (Deloitte, PwC, EY
or KPMG), and 0 otherwise
EMCONTROL Control variable for earnings management, ACFO (AACC) in regressions with AACC (ACFO)
as the dependent variable
Notes: Abbreviations in parentheses (e.g. AT) correspond to the Compustat identifier. See Panel C for
Table I. variable definitions. ***Denotes a difference in the mean (median) under a t-test (Wilcoxon rank-sum test)
Descriptive statistics with a two-tailed p-value of less than 0.01
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PSCORE |TACC| |AACC| GAO AAER AACC ACFO SIZE ROE LOSS SDROA LEV GROWTH OPCYCLE INV

PSCORE 1.000
|TACC| −0.024*** 1.000
|AACC| 0.033*** 0.564*** 1.000
GAO −0.098*** 0.019*** 0.022*** 1.000
AAER −0.048*** 0.007 0.012* 0.239*** 1.000
AACC 0.057*** −0.366*** −0.082*** −0.008 0.013* 1.000
ACFO −0.063*** 0.045*** 0.142*** 0.009 0.002 0.310*** 1.000
SIZE −0.473*** −0.190*** −0.288*** 0.070*** 0.060***−0.032***−0.060*** 1.000
ROE 0.012* −0.186*** −0.165*** −0.013** −0.003 0.140***−0.156*** 0.125*** 1.000
LOSS −0.035*** 0.254*** 0.273*** 0.014** −0.114***−0.099*** 0.311*** −0.362*** −0.271*** 1.000
SDROA −0.009 0.345*** 0.318*** 0.017*** −0.003 −0.072*** 0.196*** −0.248*** −0.203*** 0.376*** 1.000
LEV −0.262*** 0.001 −0.031*** 0.040*** −0.006 −0.053*** 0.170*** 0.385*** 0.051*** −0.059*** −0.021*** 1.000
GROWTH −0.001 0.368*** 0.223*** 0.016** 0.023***−0.013* 0.000 −0.125*** 0.036*** 0.0116* 0.058*** −0.072*** 1.000
OPCYCLE 0.002 0.030*** −0.082*** −0.022*** −0.011 −0.084***−0.018** 0.069*** 0.013* −0.027*** −0.028*** 0.113***−0.055*** 1.000
INV 0.210*** −0.048*** −0.009 −0.012* −0.004 0.069*** 0.089*** −0.115*** 0.036*** −0.134*** −0.079*** −0.013* −0.076*** −0.180*** 1.000
BIG4 −0.126*** −0.026*** −0.057*** 0.040*** 0.0217***−0.024*** 0.006 0.207*** 0.012* −0.019*** −0.018*** −0.024***−0.008 0.045*** −0.025***
Notes: See Table I, Panel C for variable definitions. *,**,***Denote a two-tailed p-value of less than 0.10, 0.05 and 0.01, respectively
earnings
Reporting

87
quality and

management

Table II.
Univariate
Pearson correlations
 JAAR 4.2 Accounting standards and earnings management
20,1 Table IV reports the regression results of Equation (5) for the full sample in Models (1) and
(2). H2 and H3 predict different coefficients on the PSCORE variable for the different
earnings management strategies, with a positive (negative) coefficient when signed AACC
(ACFO) is the dependent variable. In terms of AACC, the positive coefficient of 0.004,

88
|TACC| |AACC| GAO AAER
Model (1) Model (2) Model (3) Model (4)

PSCORE −0.003*** (−3.96) −0.002*** (−3.96) −0.196*** (−3.90) −0.174** (−2.17)

SIZE −0.004*** (−4.84) −0.006*** (−13.69) 0.147*** (3.43) 0.278*** (5.08)
ROE −0.022*** (−6.03) −0.008*** (−7.18) −0.071*** (−2.76) −0.146** (−2.07)
LOSS 0.001 (1.51) 0.002*** (7.10) 0.071* (1.79) −0.088 (−1.04)
−0.335 (−0.84)
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SDROA 0.269*** (6.39) 0.095*** (5.85) 0.075 (0.42)

LEV 0.034*** (4.67) 0.019*** (6.64) 0.111 (0.50) −0.976** (−2.24)
GROWTH 0.074*** (7.95) 0.023*** (14.07) 0.307*** (4.45) 0.594*** (5.47)
OPCYCLE 0.009*** (6.69) 0.000 (0.16) −0.189** (−2.06) −0.136 (−0.85)
INV 0.028*** (2.88) 0.032*** (5.50) 0.505 (0.75) 0.455 (0.50)
BIG4 −0.007** (−2.16) −0.002 (−1.13) 0.271 (1.32) 0.030 (0.07)
CONSTANT 0.150*** (4.09) 0.081*** (4.38) −3.129*** (−4.73) −6.422*** (−6.24)
Industry FE Yes Yes Yes Yes
Year FE Yes Yes Yes Yes
n 27,498 27,110 27,498 27,498
Adj./Pseudo R2 0.287 0.241 0.065 0.105
Notes: This table reports the results from linear regressions, in Models (1) and (2), and logistic regressions, in
Table III. Models (3) and (4), of reporting quality on the reliance on principles-based accounting standards (quintile
Linear and logistic ranked PSCORE variable) and controls for innate firm characteristics. The t-statistics in parentheses are
regression results with calculated using robust standard errors clustered by firm. See Table I, Panel C for variable definitions.
reporting quality *,**,***Denote a two-tailed p-value of less than 0.10, 0.05 and 0.01, respectively

AACC ACFO AACC ACFO

Model (1) Model (2) Model (2) Model (4)

PSCORE 0.004*** (7.19) −0.006*** (−6.97) 0.003*** (4.24) −0.003*** (−3.66)

SIZE −0.001 (−1.45) −0.001 (−0.70) −0.002** (−2.08) 0.002 (1.49)
ROE 0.024*** (12.61) −0.025*** (−12.03) 0.013** (2.06) −0.024** (−2.09)
LOSS −0.002*** (−3.79) 0.008*** (11.21) −0.000 (−0.36) 0.002* (1.77)
SDROA −0.075*** (−5.77) 0.121*** (6.40) 0.000 (0.01) 0.033 (0.89)
LEV −0.043*** (−8.82) 0.093*** (15.03) −0.027*** (−4.07) 0.082*** (9.53)
GROWTH −0.000 (−0.11) 0.007** (2.51) 0.004 (1.07) −0.003 (−0.79)
OPCYCLE −0.012*** (−10.61) 0.003 (1.59) −0.009*** (−7.44) 0.007*** (4.54)
INV 0.015* (1.96) 0.192*** (14.30) −0.024** (−2.05) 0.170*** (10.92)
BIG4 −0.007** (−2.41) 0.019*** (4.13) −0.009** (−2.43) 0.008 (1.51)
EMCONTROL 0.332*** (32.47) 0.460*** (33.86) 0.502*** (23.57) 0.731*** (26.91)
CONSTANT 0.006 (0.19) −0.088*** (−4.08) 0.025 (0.82) −0.085*** (−3.16)
Industry FE Yes Yes Yes Yes
Year FE Yes Yes Yes Yes
n 27,110 27,110 4,947 4,947
Adj. R2 0.196 0.286 0.402 0.462
Notes: This table reports the results from linear regressions of earnings management on the reliance on
Table IV. principles-based accounting standards (quintile ranked PSCORE variable) and controls for innate firm
Linear regression characteristics for the full sample in Models (1) and (2), and for suspect firms in Models (3) and (4). The
results with earnings t-statistics in parentheses are calculated using robust standard errors clustered by firm. See Table I, Panel C
management for variable definitions. *,**,***Denote a two-tailed p-value of less than 0.10, 0.05 and 0.01, respectively
 significant at a 1 percent level, indicate increasing accrual earnings management for firms Reporting
relying more on principles-based standards. In terms of ACFO, the negative coefficient quality and
of −0.006, significant at a 1 percent level, indicate increasing real earnings management for earnings
firms relying more on rules-based standards. A change in ACFO by 0.6 percent with the
change in PSCORE is economically large, given that the median cash flows from operations management
across all observations is 8.0 percent of total assets. These results are consistent with H2
and H3 that a trade-off effect exists regarding earnings management strategies with respect 89
to accounting standard characteristics.
Models (3) and (4) of Table IV report the regression results for a subsample of observations
suspect of engaging in earnings management. Here, I explore the effect of earnings management
incentives by focusing on the incentive of meeting or beating the zero earnings benchmark
(Graham et al., 2005; Burgstahler and Dichev, 1997). Following Gunny (2010), I consider
observations as suspects if they have earnings or earnings changes greater than 0 but less than
0.01 of total assets. Then, I estimate Equation (5) solely for the suspect firms to increase power
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(Zang, 2012). The coefficients on PSCORE resembles the ones for the full sample in terms of sign
and level of significance, suggesting that the results identifying a trade-off between earnings
management strategies hold in an incentive setting.

4.3 Additional tests

To corroborate the main results, I perform additional tests. First, I investigate whether the SOX
legislation has any impact on the results. This legislation was implemented after the high-profile
accounting scandals in the early 2000s and was a move toward more principles-based
accounting standards. However, the (untabulated) results of estimating Equation (5) for the
fiscal years 2003–2006 do not change any inferences.
Second, I estimate the accrual reporting quality and earnings management models with
firm and year fixed effects. This is contrary to the main models that are run with industry and
year fixed effects. My conclusions remain unchanged with this approach and the coefficients
of interest have the same signs and significance levels. These results alleviate concerns that
the main tests relying on panel data could cause standard errors to correlate within years and
across time by firm.
Finally, I examine the impact of potential omitted correlated variables and endogeneity
issues because firms, to some extent, choose how they apply accounting standards, which can
cause the results to suffer from self-selection bias (e.g. Heckman, 1979). As the first stage of the
Heckman procedure, I use a probit regression to model a firm’s PSCORE using an indicator
variation of PSCORE equal to 1 for the top 2 quintile rank values, and 0 for the bottom 2
values. Second, I calculate the inverse Mills ratio (IMR) from the probit results and include it as
an additional control variable in the main regressions. The (untabulated) results show mostly
statistically significant coefficients on the IMR variables, which justifies the endogeneity
concerns. However, the concerns are alleviated since the coefficients on the PSCORE variable
are not influenced to any larger extent. In another test, I use the approach of Larcker and
Rusticus (2010), by assessing how large an endogeneity problem has to be in order to change
the main results. For this purpose, I calculate the impact threshold of a confounding variable
(ITCV ) for PSCORE in my analyses. Considering that none of the control variables has an
impact with larger magnitude than the ITCV, any unobserved confounding variable must be
more correlated with the dependent variables and PSCORE than any of the existing control
variables to overturn the results. Given that I have an adequate set of control, it is unlikely
that there is an omitted variable that would overrun the results.

5. Conclusions
Is there an association between accounting standard characteristics and reporting quality and
earnings management strategies? My findings indicate that principles-based accounting
 JAAR standards are associated with increased reporting quality. In terms of earnings management,
20,1 I find that higher reliance on principles-based standards is synonymous with accrual earnings
management whereas lower reliance is synonymous with real earnings management. These
findings suggest that rules-based standards move the main earnings management strategies
of firms to the potentially costlier side that affects cash flows from operations.
This study contributes to the research and standard-setting arena in various ways.
90 First, I offer archival evidence complementing the arguments and analytical models of
prior commentaries (Nelson, 2003; Schipper, 2003) and theoretical studies (Demski, 2004;
Ewert and Wagenhofer, 2005). I also extend empirical studies that have only analyzed
transition effects of firms switching from one set of standards to another and studies that
have left discretion over cash flows outside the research question (e.g. Barth et al., 2008;
Folsom et al., 2017). As such, this study has potential to bridge the gap between theory and
practice since it has direct implications for a number of stakeholders, such as standard
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setters, policymakers, securities regulators, researchers, investors, preparers of annual

reports and auditors. For example, combining the results and conclusions from the
empirical analyses in this study with standard-setting ambitions, previous responses to
standard setters, experiments and analytical models offer a solid background for future
development of accounting standards. Second, I extend the literature regarding earnings
management strategies and trade-off between accrual and real earnings management.
Consistent with the mechanism based on firm-level costs, I document how developing
more rules-based accounting standards can constrain the use of some earnings
management strategies but foster the use of other, that are potentially more detrimental to
future economic value. Given the evidence documented in this study, future research on
the trade-off between earnings management strategies could incorporate a variable
controlling for the reliance on principles-based vs rules-based accounting standards.
Based on this study, I also caution researchers against drawing too strong conclusions
from results regarding one form of earnings management over the other in settings where
either principles- or rules-based accounting standards dominate. In general, future
research could examine the economic consequences of increased real earnings
management due to rules-based accounting standards following Bereskin et al. (2018).
The study is subject to a number of caveats. First, the reporting quality and earnings
management measures may suffer from bias. The results must thus be interpreted with
caution. However, I analyze different measures and perform various additional tests, which
increase the validity of the study. Second, the study relies on a measure from a prior study as
the main variable of interest. While this variable has been validated by its creators and
applied in subsequent research, the details of the results should therefore be interpreted with
respect to this limitation. Third, this study analyzes characteristics within a set of accounting
standards and not differences between sets of accounting standards. This could pose as a
potential limitation and the study could have used adoption of IFRS as an alternative route.
However, accounting standard changes fundamentally alter firms’ accounting, which could
introduce bias into the study. In addition, using a single large economy and quantifying the
variation within a set of standards allows for a broad investigation and analyses within one
country simultaneously gives a natural control for the legislative environment.

Notes
1. I thank the authors for the GAO-based data set, which is available at: https://kelley.iu.edu/bpm/
activities/errorandirregularity.html
2. I thank the authors for the supplementary data set, which is available at: https://doi.org/10.1287/
mnsc.2016.2465
 3. I use the quintile rank value of PSCORE instead of the raw PSCORE measure for ease of Reporting
interpretation. This is consistent with Folsom et al. (2017) and the results are quantitatively the quality and
same with the raw measure.
earnings
4. The GAO dependent variable, results in Model (3) of Table III, is based on the IRREGULARITY
measure from Hennes et al. (2008). The (untabulated) results remain quantitatively the same when
management
all firms in the GAO data set, either due to errors or irregularities, are identified as GAO equal to 1,
and 0 otherwise.
91

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Corresponding author
Dennis Sundvik can be contacted at: [email protected]

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