Principles versus rules based standards: Differential impact on accounting quality and relevance

Abstract

AbstractThis research explores the transition from rules‐based to principles‐based accounting standards, particularly focusing on the implementation of ASC 606, and its impact on the quality and value relevance of financial reporting. The study draws on the debate between the detailed, prescriptive nature of rules‐based standards versus the flexible, judgment‐reliant principles‐based standards. Through a comprehensive empirical analysis, it finds that the adoption of ASC 606 has led to a significant improvement in accounting quality, supporting the theory that principles‐based standards, which emphasize reflecting the economic substance of transactions, result in more accurate and informative financial statements. Additionally, the paper reveals that this transition has varied effects across different industries, with the most pronounced improvements in sectors characterized by complex customer contracts and multiple performance obligations. The research further indicates an increase in the value relevance of financial reporting post‐ASC 606 adoption, suggesting that financial statements now provide more relevant information for investors, thereby enhancing market efficiency. These findings contribute to the ongoing discourse on the optimal approach to financial reporting standards, highlighting the benefits of principles‐based standards while also acknowledging the need for strong regulatory frameworks and professional judgment to mitigate the risks of earnings management and ensure high‐quality financial reporting.