Alan M. Teixeira
The University of Auckland
Abstract: There is a high level of interest in the relative merit of principles based standards versus rules based standards. At the heart of the debate appears to be the level of discretion available to managers under the alternative approaches, the consequence of which is perceived to be earnings management. This study addresses the extent to which a change in the level of discretion available to managers in measuring and reporting accounting earnings is likely to affect its informativeness.
I analyse earnings reported under an accounting standard that provided interpretive slack between the definitions of operating, abnormal and extraordinary activity. I observe inconsistent classification of activities by firms across time, consistent with firms managing these aggregations. The results suggest that this process increased the informativeness of reported earnings. In contrast, standard setters perceived the existence of discretion as reducing the informativeness of earnings and announced the removal of classificatory slack. Earnings simulated to reflect the proposed standard suggest the removal of discretion reduced earnings informativeness.
The IASB has recently proposed the removal of classificatory slack from extraordinary and abnormal earnings in its improvements project. The results of this study question the appropriateness of this proposal.
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