Do principles-based accounting standards matter? Evidence from the adoption of IFRS in China

This paper compares measures of accounting quality for 654 firms that previously used rules-based Chinese GAAP and have transitioned into principles-based International Financial Reporting Standards (IFRS) adopted in China. In particular, I examine whether principles-based standards are associated with less real earnings management, less comparability, a higher variance of change in net income, a higher ratio of change in net income to change in cash flows, a significantly lower negative correlation between accruals and cash flows, more discretionary accruals, higher informative earnings about future cash flows and higher value relevance of accounting amounts than rules-based standards. The latter accounting regime fosters more check box or compliance mentality, provides more detailed implementation guidance, emphasizes more form over substance and deploys accounting treatments not based on recognizable principles compared to the principles-based standards. These differences between the two accounting regimes are likely to affect accounting quality. In an attempt to improve the quality of financial reporting in the post-Enron era, Section 108 of the Sarbanes-Oxley Act of 2002 instructs the Securities and Exchange Commission (SEC) to conduct studies on the characteristics of rules-based and principles-based standards. This request suggests that results of my study might have implications in U.S. and other countries transitioning from rules-based to principles-based IFRS.The results suggest that principles-based standards have higher accounting quality than rules-based standards. In particular, I find that principles-based standards have less comparable accounting numbers, a significantly higher variance of change in net income, a higher ratio of the variances of the change in net income and change in cash flows, and a significantly lower negative correlation between accruals and cash flows. Further, consistent with lower quality, rules-based standards have a significantly more evidence of real earnings management (financial structuring) and a significantly less discretionary accruals. The evidence suggests that firms substitute costly real earnings manipulation with cheaper accounting earnings management as they transition from rules-based to principles-based standards. In addition, consistent with higher quality, principles-based standards have significantly higher informative earnings about future cash flows, and significantly higher value relevance of accounting amounts. This paper also contributes to the regulatory debate by providing evidence that losses and/or bad news are more value relevant in the principles-based accounting regime. Findings are similar for state-owned firms, while private owned firms have similar but weak results.