Elsevier

Advances in Accounting

Volume 58, September 2022, 100607
Advances in Accounting

Principles-based standards and conditional accounting conservatism

https://doi.org/10.1016/j.adiac.2022.100607Get rights and content

Abstract

While the regulatory push towards principles-based standards in the United States and elsewhere is based on the notion that principles-based standards are more informative to capital market participants relative to rules-based standards, we do not know how principles-based standards impact accounting conservatism for U.S. firms. Using a measure of a firm's reliance on principles-based versus rules-based standards, we contribute to the literature by empirically examining the relation between conditional accounting conservatism and use of principles-based standards for U.S. firms. We find that conditional accounting conservatism is lower for firms relying more on principles-based standards, and this association is more pronounced for firms with greater earnings management incentives. However, the negative relation between conditional conservatism and use of principles-based standards is mitigated when there are contracting or litigation concerns. Additional analysis shows that reliance on principles-based standards also reduces unconditional accounting conservatism. Our findings are robust to using alternative measures of accounting conservatism, firm fixed effects, and a difference-in-difference model. Our evidence informs the FASB and the SEC that adoption of principles-based standards comes at a cost and has implications for regulators, auditors, analysts, investors, and others.

Introduction

The FASB and regulators in other countries have been issuing an increasing number of accounting standards that are principles-based.1,2 The key advantage of principles-based standards over rules-based standards is that increased use of professional judgment in applying the standards will enable managers to better communicate the underlying economic substance of transactions and also reduce the extent of financial engineering to structure transactions to circumvent specific rules. The FASB (2002) states, “… principles-based standards would improve the transparency of financial information essential to the efficient functioning of the economy.” While principles-based standards are touted as superior to rules-based standards, the FASB (2002) acknowledges that the principles-based approach to standards could lead to abuse, whereby the principles in accounting standards are not applied in good faith consistent with the intent and spirit of the standards (emphasis added). Similarly, the SEC (2003) expressed concerns about the possible abuse of principles-based approach and ponders, “Will management and accountants tend to exercise judgment appropriately and honestly and thereby, in fact, increase the informativeness of the financial information provided to investors?”3 McEnroe and Sullivan (2012) survey auditors and the chief financial officers of Fortune 1000 firms and find that the respondents do not exhibit a clear preference for principles-based standards over rules-based standards.4

Our objective is to inform the FASB, the SEC, and others by providing empirical evidence on the relation between principles-based standards and conditional accounting conservatism, i.e., news-dependent accounting conservatism where potential economic losses are recognized in a timely manner and recognition of economic gains are delayed, as opposed to unconditional conservatism, i.e., news-independent or ex ante conservatism where book values of net assets are systematically understated (Andre, Filip, & Paugam, 2015; Beaver & Ryan, 2005; Pope & Walker, 2003).5

We focus on accounting conservatism for several reasons.6 First, conservatism is one of the oldest accounting attributes.7 Penalva and Wagenhofer (2019) note that conservatism predates legal innovations such as limited liability of equity, standard setting and regulation, auditing, widespread litigation, stock exchanges and public debt. Second, there is extensive literature on the benefits of accounting conservatism (see Ruch & Taylor, 2015; Watts, 2003a, Watts, 2003b; Zhong & Li, 2017). Penalva and Wagenhofer (2019, 622) posit that accounting conservatism is an efficient contracting mechanism, especially in debt contracting because timely recognition of losses “can act as a timely trigger to increase monitoring and even to take control of the borrowing firm.” Other benefits are that ex ante, conservatism reduces the tendency of borrowers to engage in asset substitution, i.e., investing in high-risk projects and ex post, conservatism incentivizes managers to abandon poorly performing projects sooner (Penalva & Wagenhofer, 2019). Third, both the FASB and the IASB have deemphasized conservatism in the Conceptual Framework though this decision remains controversial (IFRS Foundation, 2013). Barker and McGeachin (2015) state that both conditional and unconditional conservatism are found in accounting practice. Ewert and Wagenhofer (2021) argue that conservatism increases both firm value and accounting quality and thus, promoting neutrality at the expense of conservatism could impair accounting quality.

The potential relation between principles-based standards and accounting conservatism is an important issue in financial reporting because the regulatory push towards principles-based standards in the U.S. and elsewhere is grounded on the notion that principles-based standards offer greater economic benefits to capital market participants than rules-based standards. However, to the best of our knowledge, prior research has not examined the impact of using principles-based standards on accounting conservatism for U.S. firms. Thus, our findings are relevant to the FASB, the SEC, and the IASB in understanding the potential consequences of using principles-based standards.

Ex ante, the relation between principles-based U.S. GAAP and accounting conservatism is unclear. Regarding fair value measurements, Badia, Duro, Penalva, and Ryan (2017) and Black, Zeyun, and Cussatt (2018) find that managers report less-verifiable financial instruments, the value of which is more subject to managerial discretion, conservatively to mitigate investors' tendency to discount Level 2 and 3 instruments. However, they do not examine other contexts and we do not know whether their findings extend to settings other than fair value measurements. Folsom, Hribar, Mergenthaler, and Peterson (2017) find that higher reliance on principles-based standards improves earnings persistence and the ability of accruals to predict future cash flows. However, prior research shows that conservatism enhances the ability of earnings to predict future cash flows but inhibits the ability of earnings to predict future earnings (Bandyopadhyay, Chen, Huang, & Jha, 2010; Kim & Kross, 2005). Thus, the nature of the relation between principles-based standards and accounting conservatism is an empirical issue; it depends on whether managers use the discretion under principles-based standards to report more conservatively or more aggressively.

To test the relation between principles-based standards and accounting conservatism, we employ Folsom et al. (2017)’s PSCORE measure (described in detail in the next section) as a proxy for a firm's reliance on principles-based standards. We estimate accounting conservatism using three proxies used in prior research: Khan and Watts (2009)’s CSCORE, Basu (1997)’s asymmetric timeliness measure, and a measure developed by Ball and Shivakumar, 2005, Ball and Shivakumar, 2006, Ball and Shivakumar, 2008. Using a sample of U.S. public companies from 1994 to 2006, we find the following. First, accounting conservatism is lower for firms relying more on principles-based standards relative to firms relying more on rules-based standards. This finding holds across all three measures of conservatism and is robust to including firm fixed effects, which mitigates concerns about omitted variables representing time-invariant firm characteristics. Second, we find that when faced with incentives to communicate a favorable picture of the firm's financial position, managers exploit the discretion under principles-based standards to delay recognition of bad news, resulting in lower conservatism. Third, contracting and litigation concerns motivate firms relying on principles-based standards to enhance accounting conservatism. Finally, unconditional accounting conservatism is also lower under principles-based standards. To address endogeneity, we use a change model and conduct a difference-in-difference test, and we find that accounting conservatism increased for firms that were affected by the change from a principles-based standard to a rules-based standard.

We make several contributions to the literature on the use of principles-based standards. First, we provide empirical evidence that accounting conservatism is lower for U.S. firms relying more on principles-based standards relative to firms relying more on rules-based standards. While principles-based standards allow managers to exercise professional judgment in capturing and communicating firm performance, our results indicate that reliance on principles-based standards comes at a potential cost–lower accounting conservatism. Watts, 2003a, Watts, 2003b argues that accounting conservatism is part of an efficient contracting technology that help to mitigate agency cost arising from asymmetric information between managers and other parties. For example, conservatism reduces managers' ability and incentives to overstate earnings, which prevents overcompensation of managers (Watts, 2003a). It also benefits debtholders by quickly triggering debt covenant violations and restricting managers' ability to transfer wealth from debtholders to shareholders (Ahmed, Billings, Morton, & Stanford, 2002; Ball & Shivakumar, 2005). Overall, although accounting conservatism may introduce downward biases into financial numbers (Feltham & Ohlson, 1995; Zhang, 2000), it enhances contracting efficiency. As a result, lack of accounting conservatism prevents efficient contracting, which could lead to more deadweight losses and lower firm values (Ahmed & Duellman, 2007).

To the best of our knowledge, ours is one of the first studies to examine the relation between principles-based standards and conservatism for U.S. firms. Our findings complement Folsom et al. (2017), which finds that principles-based standards are associated with more persistent and informative earnings. We provide empirical evidence on another important attribute of earnings besides persistence. More importantly, we find that the negative relation between reliance on principles-based standards and accounting conservatism holds after controlling for discretionary accruals, providing evidence that our results are not merely reflecting earnings management.8

Our second contribution, our finding that reliance on principles-based standards lowers unconditional conservatism, is also new to the literature on principles-based standards and is potentially interesting to accounting regulators who are usually motivated to induce unconditional conservatism (Qiang, 2007). Finally, we identify two factors, contracting and litigation, that moderate the negative relation between principles-based standards and accounting conservatism.

The rest of this paper is organized as follows. The next section develops hypotheses. Section three describes our research design and the empirical models. Section four discusses the sample. Results are in section five followed by our conclusion.

Section snippets

Related research and hypotheses

Prior to Folsom et al. (2017), empirical evidence on the effects of principles-based standards on U.S. firms was scarce due to lack of data. Boone, Linthicum, and Poe (2013) finds that the likelihood of a challenge from the SEC increases with the rules-based characteristics in the accounting standard. Following Folsom et al. (2017)’s PSCORE measure, a handful of studies have examined the impact of principles-based standards. Sundvik (2019) finds that total and abnormal accruals as well as the

Measurement of principles-based standards

We use Folsom et al. (2017)’s measure of a firm's reliance on principles-based standards (PSCORE). Folsom et al. (2017) undertakes the following steps to calculate PSCORE. First, following Mergenthaler (2010) and Donelson, McInnis, and Mergenthaler (2012), they classify each accounting standard as rules-based or principles-based and calculate the Rules-Based Continuum score (RBC1) which takes into account four attributes associated with rules-based standards: bright-line thresholds, scope and

Sample

Our sample selection begins with all Compustat firms from fiscal year 1994 to 2006. Our sample period starts in 1994 and ends in 2006 because the PSCORE developed by Folsom et al. (2017) is available from 1994 to 2006. Following Khan and Watts (2009), to calculate the CSCORE, we require the total assets and book value of equity for each firm to be positive and the share price at the fiscal year-end to be greater than $1. We exclude firms in each sample year that fall in the top and bottom

Relation between principles-based standards and accounting conservatism

Table 4 presents the results of model (7) where we use CSCORE to measure accounting conservatism. We report the results for two specifications. In column 1, we include fixed effects for industry and year while column 2 includes fixed effects for year and firm. We find that in column 1, the coefficient on PSCORE, a measure of the extent to which a firm's financial reporting is impacted by principles-based standards is −0.114 and significant at the 0.01 level, indicating that accounting

Conclusion

While the regulatory push towards principles-based standards in the U.S. and elsewhere is based on the notion that principles-based standards are more informative to capital market participants relative to rules-based standards, we do not know how principles-based standards impact accounting conservatism, a fundamental attribute of earnings. Also, there is limited empirical evidence on the potential benefits and costs of using principles-based standards for U.S. firms. We contribute to the

Declaration of Competing Interest

None.

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  • Cited by (0)

    We thank Dennis Caplan (Editor), seminar participants at Bentley University, HEC Montreal, University of Colorado Denver, and three anonymous reviewers for helpful comments and suggestions on our paper

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