The Effects of Accounting Standard Setting on Accounting Quality

Mark Kohlbeck
Florida Atlantic University
and
Terry Warfield *
University of Wisconsin Madison

January 31, 2008

Financial support from the School of Business at the University of Wisconsin Madison is greatly
appreciated. We appreciate discussion with and comments received on earlier versions of this paper from
Qiang Cheng, Katherine Schipper, and seminar participants at the 2005 University of Oklahoma
Accounting Research Conference and the University of British Columbia. We also appreciate the research
assistance of Rene Si.

* Corresponding author
University of Wisconsin Madison
975 University Avenue, Madison, WI 53706
Telephone: (608) 262-1028 / Fax: (608) 263-0477
Email: twardield@bus.wisc.edu

The Effects of Accounting Standard Setting on Accounting Quality

Abstract

We investigate the accounting quality attributes of nineteen general purpose accounting

standards implemented over the past thirty years. Our research is timely given recent
criticism of U.S. standard setting, within the context of international convergence.
Evidence on how U.S. accounting standards impact accounting quality helps evaluate the
overall standard setting process. While we find no differences in earnings forecast
dispersion or persistence before and after accounting standards implemented during this
period, analyst forecast errors decrease following new standards consistent with
improved information environments for the analysts to forecast earnings. Earnings
response coefficients (ERCs) and accrual quality decrease, but the value relevance of the
balance sheet increases, consistent with the trend toward an asset/liability focus of
accounting standards. These results are consistent with FASBs adherence to definitions
of assets and liabilities (a balance sheet focus) and enhanced disclosures in implementing
standards during this period. Thus, we provide evidence based on existing standards that
can be used to assess the merits of the U.S. standard setting and to evaluate proposals on
the direction of future standard setting.

Key Words: Accounting Quality, Accounting Standard Setting. GAAP

The Effects of Accounting Standard Setting on Accounting Quality

Introduction
We investigate the impact of standard-setting over the past 30 years on various

attributes of accounting data. The attributes examined are commonly associated with the
quality of accounting reports. Specifically, we examine the impact of nineteen accounting
standards promulgated by the Financial Accounting Standards Board (FASB) on various
accounting quality metrics. Understanding how accounting standards impact accounting
quality is important for evaluating the standard setting process.
Two events motivate our research. First, Generally Accepted Accounting Principles
(GAAP) have come under increased criticism as a contributing factor in several recent
accounting and business failures. Critics argue that the standards are complex and
difficult to apply. The result is an increasing number of restatements in recent years.
Others claim that GAAP is rule-based and contains too many bright lines and exceptions
and therefore contributes to transaction-structuring to get desired reporting results. If
these claims are true, these aspects should result in lower quality accounting reports as
new standards are implemented.
In response to the accounting failures, Congress passed the Sarbanes-Oxley Act of
2002 (SOX) to address financial reporting concerns arising from management, boards of
directors, internal and external auditors, and accounting standard-setters. One issue
raised was the current orientation of accounting standards and their potential roles in the
recent accounting failures. SOX required the SEC to conduct a study of principlesbased standards to address the purported deficiencies associated with rules-based

standards. The SEC recommended that those involved in the standard-setting process
more consistently develop accounting standards that are principles-based or objectivesoriented (SEC 2003); in general, the FASB agreed with the SECs findings (FASB 2004).
As a consequence, a move towards principles-based standards has been proposed.
However, there is little empirical evidence on the attributes of accounting numbers
produced by the existing system, which can be used to assess the merits of these
recommendations.
Second, there is debate about the accounting standards that should / could be used in
cross-border filings. For example, International Financial Reporting Standards (IFRS)
are posited to be less complex and more principle-based and based on these assertions
some argue that IFRS-based statements should be acceptable for SEC filings for
companies listed in the U.S.
In this regard, the Securities and Exchange Commission (SEC) approved rules that
allow foreign registrants to file statements under IFRS without reconciliation (SEC
2007b). In addition, the SEC is accepting comments on a proposal to allow U.S.
registrants to file statements using IFRS (2007a). The new rule and the proposal are
predicated on the assertion that IFRS (possibly owing to their less complex / rules-based
attributes) produce accounting reports of substantially the same quality as those resulting
from application of U.S. GAAP.
Thus, information is needed on the quality attributes of accounting reports resulting
from the application of U.S. GAAP, and whether variation in quality is associated with
variation in relevant attributes of the standards. That is, information on the quality of U.S.

GAAP statements and variation in quality conditional on standards attributes can be used
to assess whether criticisms of U.S. GAAP have merit.
We first document attributes of the general purpose accounting standards issued by
FASB over the last thirty years. Based on recent evaluations of standard-setting systems
(SEC 2003), we evaluate each accounting standard that we investigate as to whether the
standard affects disclosure levels, was income statement- or balance sheet-based
(oriented to definitions of assets and liabilities), contained bright lines, included
implementation guidance, or allowed exceptions / alternative applications. We find that
the nineteen accounting standards contain features of both objective-based and rule-based
accounting standards. While only three standards are considered income statement-based
and three standards contain bright lines, over half of the standards include
implementation guidance or provide exceptions or alternatives.
We examine variation in accounting attributes, before and after implementation of
each standard. We specifically investigate accounting quality measured as analyst
forecast error and dispersion, earnings persistence, earnings response coefficients
(ERCs), accrual quality, and based on the explanatory power of valuation models to
provide a comprehensive review. For each accounting quality metric, we determine the
effect of each of the accounting standards after controlling for known determinants of the
accounting quality metric. The results are then combined to provide overall evidence
concerning the standard setting process.
Our evidence is mixed. Overall, we find no differences in forecast dispersion or
persistence before and after accounting standards. However, the magnitude of analyst
forecast errors decreases following new standards consistent with improved information

available to analysts. Both ERC and accrual quality metrics decrease consistent with the
trend to a balance sheet focus in accounting standards, perhaps at the expense of earnings
quality. While the overall value relevance of accounting declines over this period, the
increased value relevance of balance sheet measures supports the positive impact of
accounting standards on the quality of these accounting measures. Finally, we provide
limited evidence that analyst forecast errors increase and persistence decrease following
accounting standards that contain bright lines and implementation guidance.
Most prior research of accounting standards has considered the accounting quality
effects of one standard at a time. These studies focus on the value relevance of
information provided by the new standard or examined the economic consequences of
early adoption. Our study provides an over-time assessment of the collective accounting
quality effects of nineteen general-purpose accounting standards that were implemented
over a long period of time. Specifically we provide evidence on the merits of the U.S.
standard setting process based on existing standards.
Thus, policy makers can use the results of this comprehensive analysis in their
assessment of the future direction for standard setting. In addition, investors will benefit
from an improved understanding of the overall impact of accounting standards on the
quality of financial statement information. We also provide preliminary evidence on the
interaction between accounting quality metrics and accounting standards that should be
considered in future research.
The paper proceeds as follows. First, we discuss the motivation for examining
accounting quality attributes and develop our hypotheses. We then describe the

accounting quality metrics and develop our research design. The next section describes
the sample which is followed by our results. The final section summarizes our findings.

Motivation and Hypothesis

Much prior research has examined the accounting quality improvements associated

with the promulgation of individual standards. For example, Barth (1991) examined
alternative pension asset and liability measurements while Choi et al. (1997) examined
measurement of other post retirement benefits. Amir (1996) also investigated post
retirement benefits and found that the liability and expense components are valuerelevant conditional on sensitivity disclosures. Davis-Friday et al. (1999) find that the
recognized post-retirement benefit liability is attributed more weight in market valuation
tests compared to when firms disclosed the anticipated liability prior to SFAS 106. Ayers
(1998) found that deferred income tax data under SFAS 109 is incrementally valuerelevant compared to the prior standard. Park et al. (1999) document the value relevance
of investment accounting based on the intent inherent in the classification of investments
under SFAS 115 (held-to-maturity vs. available-for-sale).
The majority of these and other studies considered the economic consequences of
individual accounting standards, the decision to adopt early where permitted, and the
value relevance of the related recognized amounts or disclosures. Lacking in some of
these studies is whether the accounting improved.
Notable exceptions are Barth (1991) and Choi et al. (1997), which addressed
reliability of the postretirement measures, and Ayers (1998) that examined value
relevance incremental to the previous accounting methodology. However, evaluation at

the individual standard level does not permit a collective evaluation of the standardsetting process. We conduct an expanded investigation of accounting standards over
three decades to provide evidence of the effect of accounting standards on accounting
quality.1
We first review all accounting standards issued from 1980 through 2005 and identify
19 accounting standards that we classify as general purpose (non-industry-specific) see
table 1. The vast majority of the standards that were issued over this time period were
industry-specific applications (52 standards). The other remaining standards not included
addressed disclosure requirements, clarified existing standards, provided technical
corrections, or delayed effective dates.
We evaluate the nineteen accounting standards on five dimensions based on the SEC
(2005) study calling for objective-based accounting standards. The dimensions we
consider are whether the standard increases disclosure, has an asset-liability orientation
(is not income-statement based), contains bright lines, provides implementation guidance,
and includes exceptions or alternatives. There is no dominant trend. However, we do
find some patterns concerning features of both objective-based and rule-based accounting
standards that have been debated recently. While just three standards are considered
income statement-based and three standards contain bright lines, over half of the
standards include implementation guidance and eleven of the standards provide
substantive exceptions or alternatives.

In a concurrent study, Webster and Thornton (2004) compare earnings quality between the U.S. and

Canada and attribute enhanced earnings quality in Canada to its principles-based accounting standards,
which may be offset by lax regulation.

The SEC and the FASB both favor the movement toward an objectives-based
accounting model (SEC 2003 and FASB 2003). This analysis suggests that the FASB
has generally been following an asset-liability or balance sheet-based approach and
improving the disclosure environment in its general standards and limiting the use of
bright lines.2
These attributes also have differing impacts on commonly-used accounting quality
metrics. Increased disclosure enhances the information environment, which improves
accounting quality. Likewise, the limitation of bright lines should limit transaction
structuring that may result in bias and less representative reporting. The balance sheetbased approach improves the representational faithfulness of the balance sheet and may
have a positive impact on balance-sheet oriented accounting quality metrics, possibly to
the detriment of earnings and income-based metrics. However, the existence of
implementation guidance, exceptions, and alternatives reduces comparability. These
attributes may therefore be associated with lower accounting quality.
Whether accounting quality improves or not also depends on how the accounting
quality is measured. If the accounting quality metric is based on the balance sheet, we
may observe improvement because the measurements of assets and liabilities are
improved. This is more likely if the accounting standards are balance sheet-oriented.
The opposite may be true if the accounting quality metric is primarily derived from the
income statement. This is because measuring assets and liabilities can introduce

However, this conclusion is subject to the researchers interpretation and possible bias in making the

classifications.

measurement errors and possible earnings volatility, which could negatively affect
accounting quality measures based on earnings.
Taken together, we can not make an unambiguous prediction concerning the effects
of these standards. Whether or not accounting standards affect accounting quality is an
empirical question that depends on the accounting quality measure and the interaction
with the various standard attributes. We state our hypothesis in the null as follows:
Accounting quality is not associated with the implementation of accounting
standards.

Research Design
Our research design encompasses 1) measurement of accounting quality attributes,

and 2) indentifying accounting standard implementation dates. We employ accounting

quality metrics commonly used in research based on analysts, accounting characteristics,
and investors valuations that we categorize as to a particular financial statement
perspective. We employ analyst forecast error and dispersion (Lang and Lundholm 1996,
Irani and Karamanou 2003) to capture investor expectations about earnings. From an
accounting perspective, we use persistence (Dechow and Dichev 2002), earnings
response coefficients (Collins and Kothari (1987), and an accrual quality measure
(Dechow and Dichev 2002, Francis et al. 2005). Finally, the explanatory power of a
valuation model based on both balance sheet and income statement data (Collins et al.
1997) is used to provide a market perspective.
We then examine the accounting quality metrics before and after adoption of an
accounting standard. Specifically, we examine the effect of an accounting standard by

comparing each accounting quality metric before and after the accounting standard after
controlling for known quality determinants based on prior research. The specific
approaches for analysis of each individual accounting quality metric are developed in the
following sections.

3.1 Analysts Forecasts

Our first two accounting quality metrics are based on analysts forecasts forecast
error and forecast dispersion. The degree of informativeness about future earnings is a
characteristic of accounting quality. Forecast error and dispersion proxy for information
asymmetry and the extent to which accounting numbers reduce asymmetry. We draw on
the extensive research on the determinants of forecast errors and dispersion to select
control variables (for examples, see Lang and Lundholm 1996, Hope 2003, Irani and
Karamanou 2003, who use forecast error and dispersion to capture accounting quality.)
This research suggests that both forecast errors and dispersion are positively affected by
the reporting of a loss, increased earnings volatility, higher leverage, and changes in
earnings. Inverse associations are expected for the number of analysts following the firm
and size (consistent with lower information asymmetry for larger firms).
In addition, the accounting quality metric may be changing over time unrelated to the
accounting standards suggesting the need to include a trend variable (for example, see
Collins et al. 1997). The trend variable captures the effects of other factors that are
changing over time and may influence accounting quality (for example, the increase in
conference calls in the mid to late 1990s). Finally, we include an indicator variable
capturing the implementation of the accounting standard overall.

Our analysts forecast models are as follows:

LNERRORi,t (LNDISPi,t) = 0 + 1 LOSSi,t + 2 ANALYSTSi,t +
3 LNASSETSi,t + 4 EPS_VOLi,t + 5 LEVERAGEi,t + 6 %EARNi,t +
7 TRENDt + 8 STANDARDt + i,t

(1)

where LNERROR is the natural log of the absolute value of difference between actual
EPS and mean forecasted EPS3 scaled by stock price at the beginning of the year,
LNDISP measures consensus among analysts and is measured as the natural log of the
standard deviation of the analysts forecasted EPS scaled by stock price at the beginning
of the year, LOSS is an indicator variable equal to one if earnings before extraordinary
and discontinued operation is negative and zero otherwise, ANALYSTS is the decile
ranking of number of estimates scaled between zero and one, LNASSETS is the natural
log of total assets, EPS_VOL is the standard deviation of EPS over the past five periods
deflated by stock price at the beginning of lag period, LEVERAGE is total liabilities
divided by total assets, %EARN is the percentage change in earnings before
extraordinary items, TREND is a trend variable equal to the year less 1976, and
STANDARD is an indicator variable equal to one if the year identified standard is
effective and zero otherwise.

3.2 Persistence
Our earnings persistence measure is based on Dechow and Dichev (2002) who
examine the quality of accruals and earnings and Francis et al. (2005) who examined
earnings quality. Earnings persistence captures the permanence of earnings from one

The IBES forecast data is based on the last consensus forecast prior the end of the period being forecast.

10

period to the next and is estimated by regressing current period earnings on prior period
earnings. Higher earnings persistence is considered a characteristic of higher accounting
quality.
Dechow and Dichev (2002) and Francis et al. (2005) define earnings as the sum of
cash flow from operations and the change in working capital accruals. However, certain
of the accounting standards studied result in long-term accruals which are omitted in this
definition. Instead, we base our persistence measure on income before extraordinary
items to capture current and long-term accrual effects (Kormendi and Lipe, 1987, and
Collins and Kothari, 1989). Earnings persistence is measured by the estimated coefficient
from a regression of current earnings on lagged earnings.
Our review of the prior literature suggests that persistence is expected to be
increasing in growth (Collins and Kothari 1989 and Francis et al. 2002). We use the
market-to-book ratio to identify high growth firms in the formation of the portfolios and
include both a main effect and the incremental effect on persistence. A trend variable is
also included to capture overtime changes in persistence unrelated to the implementation
of the accounting standard.
We first included the effect of the accounting standard as a main effect to control for
the overall impact on earnings levels. We then include an interaction with lagged
earnings to capture the incremental effect on persistence.
The persistence model is as follows:
EARNi,t = 0 + 1 EARNi,t-1 + 2 MBi,t + 3 ( EARNi,t-1 * MBi,t ) +
4 TRENDt + 5 STANDARDt + 6 (EARNi,t-1 * STANDARDt) + i,t

11

(2)

where EARN is income before extraordinary items scaled by average assets, MB is the
market-to-book ratio, and other variables are as previously defined.

3.3 Earnings Response Coefficients

Earnings response coefficients have been used in the literature as a proxy for
information content of accounting earnings (Kormendi and Lipe 1987, Easton and
Zmijewski 1989, and Collins and Kothari 1989). An ERC is the slope coefficient on the
regression of returns (or abnormal returns) on change in earnings (or unexpected
earnings). ERCs may therefore be used as a proxy for accounting quality because it
measures the mapping of earnings into returns and provides decision useful information
from an equity investor perspective (Schipper and Vincent 2003).
In our settings, we measure returns as annual shareholder returns and earnings as the
change in earnings during the year.4 The ERC represents the coefficient on the change in
earnings. We also include a trend variable to capture overtime changes in ERCs
unrelated to the implementation of the accounting standard.
We include the effect of the accounting standard as a main effect to control for
overall impact on returns. We then include an interaction with change in earnings to
capture the incremental effect on ERCs.
The ERC model is as follows:
RETURNi,t = 0 + 1 EARNi,t + 2 TRENDt + 3 STANDARDt +
4

We consider alternative specifications for this model, including controls for additional determinants of

ERCs (natural log of assets, leverage, ratio of market value of equity to book value of equity, and earnings
volatility), in later sensitivity tests.

12

4 (EARNi,t * STANDARDt) + i,t

(3)

where RETURN is the annual return on shareholder equity, EARN is the change in
earnings before extraordinary items divided by beginning of year market value of equity,
and other variables are as previously defined.

3.4 Accrual Quality

We follow Dechow and Dichev (2002) and Francis et al. (2005) to estimate a proxy
for accrual quality that is commonly used in the literature. This measure focuses on the
uncertainty in the accruals as it is based on the extent that accruals map into operating
cash flow realizations.
While Dechow and Dichev (2002) focuses on current working capital accruals,
Francis et al. (2005) extend the model to total current accruals. They include change in
sales and gross property, plant, equipment from the modified Jones model (Dechow et al.
1995) in explaining total current accruals. The result is the following total current
accrual model.
TCA = 0 + 1 CFOi,t+1 + 2 CFOi,t + 3 CFOi,t-1 + 4 SALESi,t +
5 PPEi,t + i,t

(4)

where TCA is total accruals and equals the change in current assets less the change in
current liabilities less the change in cash plus the change in short-term debt, CFO is cash
flow from operations, SALES is the year-to-year change in sales, and PPE is gross level
of property, plant and equipment. All variables are scaled by average assets in year t.
Equation (4) is then estimated annually on a cross-sectional basis for each of Fama
and Frenchs (1997) 48 industry groups with at least 20 firms. The firm-specific

13

residuals from this estimation are used to form the accrual quality metric. Specifically,
the firm-specific accrual quality metric equals the standard deviation of the residuals for
the past five years for each firm.
We then develop an estimating equation that includes known determinants for accrual
quality. Following Dichow and Dichev (2002) and Francis et al. (2005), we expect that
accrual quality is negatively associated with smaller firms, greater cash flow variability,
longer operating cycles, and reporting of losses. A trend variable is also included to
capture overtime changes in accrual quality unrelated to the implementation of the
accounting standard. Finally, an indicator variable that captures the effect of the
accounting standard is included.
Our accrual quality model is as follows.
SD_AQi,t = 0 + 1 LNASSETSi,t + 2 SD_CFOi,t + 3 SD_SALESi,t + 4
LNCYLCEi,t + 5 LOSSi,t + 6 TRENDt + 7 STANDARDt + i,t

(5)

where SD_AQ is the standard deviation of the residual from the annual estimation of
equation (4) over the past five years for each industry, LNASSETS is the natural log of
total assets, SD_CFO is the standard deviation of cash flow from operations over the past
five years, SD_SALES is the standard deviation of sales over the past five years,
LNCYCLE is the natural log of one plus days in receivable and days in inventory, LOSS
is an indicator variable equal to one if earnings before extraordinary items and
discontinued operations is negative and zero otherwise, and other variables are as
previously defined.

14

3.5 Valuation
Our final accounting quality metric is derived from valuation models that consider
balance sheet and earnings information. Collins et al. (1997) investigated over-time
changes in incremental explanatory power using three valuation models a book value of
equity model, an earnings model, and a model incorporating both variables. We follow a
similar approach and estimate the following three models.5
PRCi,t = 0 + 1 BVPSi,t + i,t

(6)

PRCi,t = 0 + 2 EPSi,t + i,t

(7)

PRCi,t = 0 + 1 BVPSi,t + 2 EPSi,t + i,t

(8)

where PRC is the market value per share three months following the end of the year,
BVPS is the book value of common equity per share as of the end of the year, and EPS is
the earnings before extraordinary items per share.
The explanatory powers (adjusted R2s) from the annual estimations of these three
equations are then estimated and compared from before to after the implementation of
each standard.

Samples and Data

Our sample begins with Compustat firms with available data from 1976 to 2005. We

first eliminate observations that lack lagged data and non-December year-ends. We
eliminate non-December year-ends to simplify identification of when specific standards

In later sensitivity tests, we also control for loss firms as prior research suggests that valuation multiples

differ between loss firms and profit firms (Hayn 1995 and Collins et al. 1999).

15

are applicable to firms. Our preliminary sample consists of 138,701 firm-year

observations.
To maximize the power of each of our tests, we form separate samples for each
accounting quality measure based on data availability specific to that measure (table 2).
For example, IBES data is only required for the analyst forecast sample. We eliminate
extreme value observations in the persistence, ERC, and valuation samples consistent
with prior research. Extreme observations are defined as share prices, book value per
share, or earnings per share exceeding $1,000 per share in the valuation sample; return on
average assets in excess of 200% in the persistence sample; and returns exceeding 100%
or change in earnings scaled by beginning of year share prices exceeding 10 in the ERC
sample. Sample sizes vary from 47,750 firm-year observations for the forecast sample to
135,164 firm-year observations for the persistence sample. The availability of IBES data
and variables to construct our accruals measures are the most restrictive constraints in
forming our samples resulting in the forecast and accrual quality samples being the
smallest.6
Mean and median statistics are reported in table 3 and are different between the
samples. The descriptive data suggest on average the forecast sample contains
substantially larger and more profitable firms than the other samples, consistent with
IBES coverage. As the sample sizes increase, smaller and less profitable firms are
included.

The analysis suggests that in general, the forecast and accrual samples are subsets of the ERC and

valuation samples, which in turn are subsets of the persistence sample.

16

The median data (panel B) shows less variability consistent with extreme
observations influencing the mean statistics. The forecast sample still indicates that it is
populated with larger firms relative to the other four samples. However, the median
leverage, market to book ratio, and earnings are similar across the sample. The median
data also show positive earnings across all samples. Even though average earnings are
negative for four of the five samples, over one-half of the observations in each sample
report positive earnings.

Results
We identify nineteen accounting standards for our study and focus on the period

before and after each accounting standard.7 However, more than one standard became
effective in certain years. For example, both SFAS 87 and SFAS 88 became effective for
fiscal years beginning after December 15, 1986. In this situation, we jointly consider all
accounting standards implemented during a year as one event. We therefore investigate
eleven standard setting events over the past thirty years. Our results are therefore
conditional on this grouping.
For each of the eleven accounting standard events, we estimate the accounting quality
model for each accounting quality metric we investigate. The estimated coefficient on
the accounting standard variables represents the shift in the accounting quality metric
following the implementation of the accounting standard and controlling for other know
determinants. We combine the results from individual standards for each accounting
quality metric in a meta-analysis to make inferences about the overall standard setting

The nineteen accounting standards are listed in table 1 and discussed earlier.

17

process. Specifically, we take the mean of the coefficients associated with each
accounting standard event and test whether this mean is significantly different from zero.8
We limit the number of years included in each of the estimations for each accounting
quality models to 1) reduce sampling bias from including all years in each estimation and
2) strengthen the generalizability of our results. Our sample period for each accounting
standard includes the four-year period that ends two years before and the four-year period
that begins two years after the implementation of each standard (eight years in total). The
year of implementation, the preceding year, and the following year are excluded to avoid
adoption year effects. Given the long time period over which standards are implemented,
different years data are relevant for different standards. This serves to randomize the
effects of non-accounting effects across the tests. We organize the following discussion
of our results by accounting quality metric and provide an overall summary at the end of
this section.

5.1 Analyst Forecast-based Measures

We estimate equation (1) for each of the eleven accounting standard events defining
the dependent variable as the natural log of the forecast error and the natural log of
forecast dispersion (table 4). The mean adjusted R2 equals 15.1% (15.7%) for the
forecast error (forecast dispersion) model. The control variables are not presented here or

We consider both t-statistics and Z-statistics when determining the significance of the mean coefficients.

18

in later tables for brevity. However, the estimation results with respect to the control
variables are generally as expected.9
The estimated coefficients for six of the accounting standards for the forecast error
model are significant, five of which are negative. The mean coefficient is also significant
and negative (-0.0080, p-value < 0.10). Collectively, the results suggest decreased
forecast errors are associated with the standard setting process.
Significant coefficients are obtained for five of the accounting standards when
estimating the forecast dispersion model - three are positive and two are negative.
However, the mean coefficient is not significant. There is no consistent evidence with
respect to forecast dispersion.

5.2 Accounting-based Measures

The three accounting-based measures are: persistence, ERCs, and accrual quality.
We first consider the accounting standards incremental effect on persistence (the
interaction of prior periods earnings and the accounting standard variable). Equation (2)
is estimated for each accounting standard and we report the results in table 5. The mean
adjusted R2 for the persistence model is 45.5%. The estimated coefficient for the
incremental persistence is significant for each of the eleven accounting standards.
However, there is no consistency as to direction; the overall mean is not significant.
Second, we consider whether there is an incremental ERC impact and estimate
equation (3) for each accounting standard. The mean adjusted R2 is 8.3% and the

Estimation results with respect to the control variables in the other equations are only discussed if

unexpected results are found.

19

estimated coefficients are significant and negative for six of the accounting standards
(two accounting standards are positive). The overall mean is also negative and significant
(-0.0733, p-value < 0.10) consistent with decreasing ERCs. The negative coefficients
suggest the association of change in earnings to explain future returns is decreasing
following the implementation of accounting standards and is consistent with decreasing
accounting quality (as measured by ERCs).
Finally, we examine changes in accrual quality. We estimate equation (5) and report
our results in table 6. The analysis excludes SFAS 143 and SFAS 146 because the
accrual quality measure requires one year-ahead cash flow from operations. The mean
adjusted R2 is 42.5%. Five of the ten estimated coefficients for the accounting standard
effect are significant; three of which are positive. Overall, the mean effect is significant
and positive (1.9279, p-value < 0.10) indicating decreasing quality.
Combined, the overall evidence is that the accounting standards are associated with
decreasing accounting quality (lower ERCs and lower accrual quality). This evidence is
consistent with the FASBs increased focus on the balance sheet where more variability
may then be introduced to the income statement.

5.3 Valuation Measures

Our final analysis considers the explanatory power of book value per share (BVPS),
earnings per share (EPS), and combined valuation models. We perform two analyses.
First, we compare the explanatory power before and after each accounting standard using
the BVPS, EPS and combined models (table 7). We combine the adjusted R2 across
accounting standards and interpret the mean results. We find no difference between the

20

period before and the period after the accounting standards for the BVPS and combined
models. However, we do find a significant decrease in the explanatory power after the
implementation of the accounting standard for the EPS model. The mean adjusted R2
decreased from 43.7% in the before period to 37.6% in the after period, a decrease of
6.1%. This decrease is consistent with FASBs focus on the balance sheet at the possible
detriment of the income statement.
Second, we follow the approach in Collins et al. (1997) to identify the sources of the
combined adjusted R2 based on the three valuation models (table 8). We allocate the
adjusted R2 for the combined model from the before and after periods to 1) factors
common to both the BVPS and EPS models, 2) unique to the BVPS model, and 3) unique
to the EPS model. We then investigate the differences between the before and after
period for each source of information and combine the results across all accounting
standards.
We find that there is no difference in explanatory power for the common source,
unique EPS source, or the combined model. However, we do find a significant increase
in explanatory power associated with factors unique to the BVPS model of 6.4%. These
results are also consistent with a balance sheet focus in standard setting.

5.4 Summary and Sensitivity Analysis

Overall, our evidence is mixed. We find no differences in forecast dispersion or
persistence between before and after accounting standards. However, analyst forecast
errors decrease following new standards consistent with improved information
environments for the analysts to forecast earnings. ERCs and accrual quality decrease

21

consistent with the balance sheet focus of the accounting standards and the over-time
explanatory of the valuation models (decrease in explanatory power of EPS model and
increase in explanatory power associated with unique balance sheet information).
We perform a number of sensitivity tests to document the robustness of our results. In
general, we find that our results are robust and inferences are unaffected. We discuss
these tests in the following paragraphs.
We consider alternatives procedures in selecting observations for our sample and
measuring our variables. First, we exclude from the estimations approximately 10,000
observations in the forecast sample that are missing forecast dispersion metrics because
there is only one analyst. We assume the dispersion metric equals zero for these firms
and included them in our sample. Second, where data is available, we include only firms
in the tests for which the standard is more likely to have an impact. For example, the
firm must have a defined benefit pension plan when investigate the effect of SFAS 87
and 88. Third, we expand the sample for each standard to include all years except the
three years centered on the year of implementation rather than a four-year period before
and after the implementation of the standard. Finally, the distributions of many of our
independent variables indicate the potential for significant outliers. We therefore
winsorized a number of the variables at the 1st and 99th percentile and re-estimate our
models. Our findings are robust, except the marginal accrual quality results are no longer
significant in each case.
We also consider alternative specifications for two our accounting quality models.
The ERC model (equation 3) is based on the change in earnings. We consider an ERC
model based on the level of earnings. Prior research also suggests a number of additional

22

determinants of ERCs including the natural log of assets, leverage, ratio of market value
of equity to book value of equity, and earnings volatility. We incorporate these
additional variables as main effects and interactions with the change in earnings to
capture the incremental effect on ERCs. Our results are not affected.
Prior research suggests that loss firms are valued differently than profitable firms
(Collins et al. 1997 and Hayn 1995). We therefore control for loss firms by 1) estimating
the ERC and valuation models separately for profitable and loss firms and 2) including a
loss firm indicator and interactions with book value and earnings per share in the
valuation model. ERC results weaken, but are consistent with those reported. The
analysis of the valuation models suggests that decreases in the explanatory power of the
EPS model is driven by loss firms and the differences related to the balance sheet only
model are driven by the profitable firms. These results are consistent with prior research
and our overall findings.
Finally, accounting standard attributes vary widely as discussed above and presented
in table 1. We incorporate these attributes to provide preliminary evidence as to whether
differential effects exist and inform as to which attributes have positive or negative
influence on accounting quality. Specifically, we compare the estimated coefficients
based on classifying the accounting standards with respect to whether the standard
increases disclosure, focuses on the income statement, contains bright lines, includes
separate implementation guidance, and allows exceptions or alternatives.10

10

These results are contingent on the classifications that we made and are therefore subject to researcher

interpretation and bias. However, this classification allows an analysis to provide preliminary information.

23

Our evidence is qualified because our classifications are necessarily judgmental and
limited because we are making comparisons over only eleven coefficients. We find that
consistent with our earlier discussion, bright lines, implementation guidance, and
existence of exceptions or alternatives are associated with lower persistence and
increased forecast errors. However, bright lines and exceptions or alternatives are also
associated with increasing quality (lower dispersion and higher ERCs). Evidence with
respect to these comparisons is mixed probably due to competing effects from the various
attributes.

Conclusion
We examine the effect of eleven general purpose accounting standard setting events

(nineteen accounting standards) on accounting quality during the period from 1976 to
2005. We consider accounting quality based on analyst forecasts (errors and dispersion),
accounting information (persistence, ERCs, and accrual quality), and valuation models.
We therefore provide comprehensive empirical evidence on the merits of accounting
standard setting process.
Overall, we provide evidence consistent with the FASBs asset-liability (or balance
sheet) focus and an improvement in the accounting information environment. Forecast
errors are lower and the unique explanatory power in a valuation model attributable to
book value per share increases. However, we also provide evidence of decreasing
accounting quality in terms of persistence and accrual quality, as well as decreased
explanatory power of earnings per share value models. These results are also generally
consistent with a balance sheet focus.

24

Our study provides an over-time assessment on the accounting quality effects of

accounting standard setting process. The results are generally supportive of the FASBs
recent standards, which focus on assets and liabilities and expand disclosures. However,
there are numerous exceptions and extensive implementation guidance which may not
advance the objective of higher quality accounting standards. Interpretations of the
results must be conditioned on the accounting quality metrics and proxies for the impact
of the accounting standards on individual companies.

25

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28

Table 1 - Accounting Standards from 1980 to 2002

Standard

Effective Date

Asset / Liability

(for fiscal years beginning after the

date unless otherwise indicated)

Effect on
Disclosure
Level

Income
Statement
Based

Bright
Lines

Implementation
Guidance

Exceptions /
Alternatives

SFAS 43

December 15, 1980

Compensated absence liability

None

No

No

No

No

SFAS 48

June 15, 1981

Accounts Receivable (Sales)

None

Yes

No

EITF 6 related

No

SFAS 52

December 15, 1982

Receivables and payables

arising form foreign currency
transactions

Increase

No

No

FIN 37

No

SOP 93-4
EITF 8 direct, and 5 related

SFAS 68

Arrangements after 12/31/1982

Accrued R&D

Increase

Yes

No

EITF 1 related

No

SFAS 80

Futures contracts entered into

after December 31, 1984

Market value of future contracts

Increase

No

No

Implementation Guide

Yes / hedge
accounting if criteria
met

December 15, 1986

Accrued pension costs, prepaid

pension costs, additional
minimum liability, pension
intangible

Increase

Settlement of defined benefit

plans and termination benefits

Increase

No

Yes /
majority
owned

No

Yes / if control is
temporary

No

No

Implementation Guide

Yes / Transition
Obligation

SFAS 87

SFAS 88

December 15, 1986

Examples in Appendix B
No

No

Yes /
Corridor

No

Implementation Guide
Examples in Appendix B
Implementation Guide

Yes / PSC, AML,

Unrealized G?/L

No

Examples in Appendix B

SFAS 94

Ending after December 15,

1988

Consolidation

None

SFAS 106

December 15, 1992

Accrued OPEB liability

Increase

Staff Position
Examples in Appendix C
SFAS 109

December 15, 1992

Deferred tax assets and

liabilities

Increase

No

No

Implementation Guide
Staff Positions (2)
Examples in Appendix B

29

Paragraph 9

Standard

Effective Date

Asset / Liability

(for fiscal years beginning after the

date unless otherwise indicated)

Effect on
Disclosure
Level

Income
Statement
Based

Bright
Lines

Implementation
Guidance

Exceptions /
Alternatives

SFAS 115

December 15, 1993

Available-for-sale securities

None

No

No

Implementation Guide

Yes / HTM, AFS

SFAS 121

December 15, 1995

Non-current assets /
Impairments

None

No

No

No

Paragraph 3

SFAS 123

December 15, 1995, superseded

by SFAS 123R (removed
exception)

None

Increase

Yes

No

EITF 3 direct and 9 related

Yes / Intrinsic

Derivatives

Increase

SFAS 133

June 15, 2000 (SFAS 137)

Examples in Appendix B
No

No

Implementation Guide (DIG)

Implementation Guidance in
Appendix A

SFAS 141

SFAS 142

Combinations after June 30,

2001

Acquired assets and liabilities

December 31, 2001

Intangible Assets / Impairments

None

No

Increase

No

FN 5 - >
50%

No

Staff Position

Yes / FV and CF
Hedges

No

Implementation Guidance in
Appendix A
Staff Position

Paragraph 8

Implementation Guidance in
Appendix A
SFAS 143

June 15, 2002

Asset retirement obligations

Increase

No

No

Implementation Guidance in
Appendix A

No

SFAS 144

December 15, 2001

Non-current assets /
Impairments

None

No

No

Staff Position

Paragraph 5

Liabilities

Increase

SFAS 146

Disposals after December 31,

2002

Overall

Implementation Guidance in
Appendix A
No

No

Staff Position

No

Implementation Guidance in
Appendix A
12 Increased
Disclosure Level

30

3 are Income
Statement
Based

3 Include
Bright
Lines

16 provided Implementation
Guidance

11 Include
Exceptions or
Alternatives

Table 2 - Sample Selection

Sample
Compustat firm-year
observations with assets from
1976 to 2005
Less:
Missing lag data
Non-December Yearends
Missing IBES data
Missing CRSP data
Missing Compustat data items
Negative shareholders equity
Extreme observations
Insufficient observations per
industry
Insufficient lag data
Final sample

ERC

Accrual
Quality

Forecast

Persistence

Valuation

261,457

261,457

261,457

261,457

261,457

22,251
100,505
138,701
90,709

22,251
100,505
138,701

22,251
100,505
138,701

22,251
100,505
138,701

22,251
100,505
138,701

242

943

51,409
983

42,214

2,594

1,880

47,309
722
2,799
32

740
47,750

135,164

31

84,429

37,100
58,647

87,839

Table 3 Mean / Median Descriptive Statistics Across Pooled Samples

Panel A: Mean Statistics
Sample
Variables

N
ASSETS
LEVERAGE
MB
EARN
EARN
LNERROR
LNDISP (N=37,905)
RETURN
SD_AQ
PRC
BVPS
EPS

Forecast

Persistence

47,750
6,721
0.58
2.68
0.0069
0.1523
0.0235
0.0067

135,164
4,137
0.94
2.71
-0.0329
0.1830

ERC

Accrual
Quality

84,429
4,585
0.58
2.44
-0.0109
-0.0727

58,647
2,281
0.93
2.47
-0.0448
-0.2154

Valuation

87,839
4,049
0.54
3.41
-0.0079
0.3810

0.1150
51.356
19.58
11.72
0.98

32

Table 3 Mean / Median Descriptive Statistics Across Samples (cont.)

Panel B: Median Statistics
Sample
Variables

Persistence

47,750

135,164

84,429

58,647

87,839

ASSETS

537

180

261

220

209

LEVERAGE
MB

0.58

0.59

0.57

0.56

0.55

1.76

1.51

1.52

1.44

1.61

EARN

0.0314

0.0228

0.0254

0.0399

0.027

%EARN
LNERROR

0.0915

0.0547

0.0679

0.0239

0.076

LNDISP

0.0015

ERC

Accrual
Quality

Forecast

Valuation

0.0028

RETURN

0.0814

SD_AQ
PRC
BVPS
EPS

11.723
14.31
8.08
0.74

Variables are defined as follows: ASSETS is total assets, LEVERAGE is total liabilities divided by total assets, MB is
an indicator variable equal to one if the portfolio was assigned firms with market-to-book ratios greater than the annual
median, EARN is income before extraordinary items scaled by average assets, %EARN is the percentage change in
earnings before extraordinary items, LNERROR is the natural log of the absolute value of difference between actual
EPS and mean forecasted EPS scaled by stock price at the beginning of the year, LNDISP is the natural log of the
standard deviation of the forecasted EPS scaled by stock price at the beginning of the year, RETURN is the annual
return on shareholder equity, SD_AQ is the standard deviation of the residual from the annual estimation of equation
(4) over the past five years for each industry, PRC is the market value per share three months following the end of the
year, BVPS is the book value of common equity per share as of the end of the year, and EPS is the earnings before
extraordinary items per share.

33

Table 4 Analyst Forecast Error and Dispersion

LNERRORi,t (LNDISPi,t) = 0 + 1 LOSSi,t + 2 ANALYSTSi,t + 3 LNASSETSi,t +
4 EPS_VOLi,t + 5 LEVERAGEi,t + 6 %EARNi,t + 7TRENDt + 8STANDARDt + i,t
Standard (s)

Forecast Error

Forecast
Dispersion

SFAS 43

-0.0090

0.0045 ***

SFAS 48

-0.0223 **

0.0036 ***

SFAS 52 and 68

-0.0158

0.0033 ***

SFAS 80

0.0260 **

SFAS 87 and 88

0.0084

-0.0011

SFAS 94

0.0055

-0.0024 ***

SFAS 106, 109, and 115

SFAS 121 and 123

-0.0221 ***
0.0034

0.0010

-0.0036 ***
-0.0002

SFAS 133

-0.0178 ***

0.0001

SFAS 141, 142, and 144

-0.0188 ***

0.0011

SFAS 143 and 146

-0.0258 ***

0.0002

Mean accounting standard coefficients

-0.0080 *

0.0005

Mean adjusted R

15.1%

15.7%

Number of Standards with

Significant Positive Coefficients

Significant Positive Coefficients

* / ** / *** significant at the 0.10 / 0.05 / 0.01 level.

1

Variables are defined as follows: LNERROR is the natural log of the absolute value of difference between actual EPS
and mean forecasted EPS scaled by stock price at the beginning of the year, LNDISP is the natural log of the standard
deviation of the forecasted EPS scaled by stock price at the beginning of the year, LOSS is an indicator variable equal
to one if earning before extraordinary and discontinued operation is negative and zero otherwise, ANALYSTS is the
decile ranking of number of estimates scaled between zero and one, LNASSETS is the natural log of total assets,
EPS_VOL is the standard deviation of EPS over the past five periods deflated by stock price at the beginning of lag
period, LEVERAGE is total liabilities divided by total assets, %EARN is the percentage change in earnings before
extraordinary items, TREND is a trend variable equal to the year less 1976, and STANDARD is an indicator variable
equal to one if the year identified standard is effective and zero otherwise.

34

Table 5 Persistence and ERCs

EARNi,t = 0 + 1 EARNi,t-1 + 2 MBi,t + 3 ( EARNi,t-1 * MBi,t ) + 4 TRENDt +
5 STANDARDt + 6 (EARNi,t-1 * STANDARDt) + i,t
RETURNi,t = 0 + 1 EARNi,t + 2 TRENDt + 3 STANDARDt +
4 (EARNi,t * STANDARDt) + i,t
Standard (s)

Incremental
Persistence

Incremental ERCs

SFAS 43

0.1194 ***

-0.1518 ***

SFAS 48

0.1173 ***

-0.2513 ***

SFAS 52 and 68

0.0467 ***

-0.2588 ***

SFAS 80

0.0578 ***

-0.1852 ***

SFAS 87 and 88

-0.0531 ***

-0.1329 ***

SFAS 94

-0.0655 ***

-0.1152 ***

SFAS 106, 109, and 115

0.0134 *

0.1199 ***

SFAS 121 and 123

0.0435 ***

0.1030 ***

SFAS 133

-0.0579 ***

-0.0051

SFAS 141, 142, and 144

-0.0445 ***

0.0347

SFAS 143 and 146

-0.0299 ***

0.0357

Mean accounting standard coefficients

Mean adjusted R

0.0133
45.5%

-0.0733 *
8.3%

Number of Standards with

Significant Positive Coefficients

Significant Positive Coefficients

* / ** / *** significant at the 0.10 / 0.05 / 0.01 level.

1

Variables are defined as follows: EARN is income before extraordinary items scaled by average assets, MB is an
indicator variable equal to one if the portfolio was assigned firms with market-to-book ratios greater than the annual
median, RETURN is the annual return on shareholder equity, EARN is the percentage change in earnings before
extraordinary items, TREND is a trend variable equal to the year less 1976, and STANDARD is an indicator variable
equal to one if the year identified standard is effective and zero otherwise.

35

Table 6 Accrual Quality

SD_AQi,t = 0 + 1 LNASSETSi,t + 2 SD_CFOi,t + 3 SD_SALESi,t + 4 LNCYLCEi,t +
5 LOSSi,t + 6 TRENDt + 7 STANDARDt + i,t
Standard (s)

Accrual Quality

SFAS 43

6.1209 ***

SFAS 48

1.2278
-0.2748

SFAS 52 and 68
SFAS 80

2.4909

SFAS 87 and 88

4.4493

SFAS 94

3.5610

SFAS 106, 109, and 115

-15.1032 ***

SFAS 121 and 123

-23.5200 ***

SFAS 133

26.9545 ***

SFAS 141, 142, and 144

13.3731 *
N/A

SFAS 143 and 146

Mean accounting standard coefficients
Mean adjusted R2

1.9279 *
42.5%

Number of Standards with

Significant Positive Coefficients

Significant Positive Coefficients

* / ** / *** significant at the 0.10 / 0.05 / 0.01 level.

1

Variables are defined as follows: SD_AQ is the standard deviation of the residual from the annual estimation of
equation (4) over the past five years for each industry, LNASSETS is the natural log of total assets, SD_CFO is the
standard deviation of cash flow from operations over the past five years, SD_SALES is the standard deviation of sales
over the past five years, LNCYCLE is the natural log of one plus days in receivable and days in inventory, LOSS is an
indicator variable equal to one if earnings before extraordinary and discontinued operation is negative and zero
otherwise, TREND is a trend variable equal to the year less 1976, and STANDARD is an indicator variable equal to
one if the year identified standard is effective and zero otherwise.

36

Table 7 Explanatory Power of Valuation Models

BVPS Model:
PRCi,t = 0 + 1 BVPSi,t + i,t
EPS Model:
PRCi,t = 0 + 2 EPSi,t + i,t
Combined Model: PRCi,t = 0 + 1 BVPSi,t + 2 EPSi,t + i,t

BVPS Model
Standard (s)

Before
Standard

After
Standard

Mean Annual R2
EPS Model
Before
Standard

After
Standard

Combined Model
Before
Standard

After
Standard

SFAS 43

0.494

0.541

0.572

0.368

0.608

0.596

SFAS 48

0.521

0.536

0.575

0.358

0.627

0.591

SFAS 52 and 68

0.544

0.530

0.539

0.359

0.638

0.586

SFAS 80

0.554

0.524

0.530

0.345

0.639

0.580

SFAS 87 and 88

0.618

0.575

0.455

0.348

0.670

0.634

SFAS 94

0.594

0.583

0.478

0.328

0.652

0.635

SFAS 106, 109, and 115

0.575

0.430

0.348

0.324

0.634

0.480

SFAS 121 and 123

0.590

0.344

0.339

0.160

0.635

0.380

SFAS 133

0.430

0.581

0.324

0.366

0.480

0.644

SFAS 141, 142, and 144

0.366

0.588

0.258

0.492

0.415

0.683

Mean all standards

0.529

0.544

0.437

0.376

0.597

0.600

Comparisons of Before and After

0.015

-0.061 **

0.003

* / ** / *** significant at the 0.10 / 0.05 / 0.01 level.

1

Variables are defined as follows: PRC is the market value per share three months following the end of the year, BVPS is the book value of common equity per share as of the end
of the year, and EPS is the earnings before extraordinary items per share.

37

Table 8 Components of Explanatory Power of Valuation Models

Mean Annual R2
After Standard

Before Standard
Standard (s)

Common

BS Only

IS Only

SFAS 43

0.466

0.034

0.123

SFAS 48

0.454

0.037

SFAS 52 and 68

0.469

SFAS 80

Combined

Common

BS Only

IS Only

0.623

0.421

0.174

0.057

0.103

0.594

0.391

0.202

0.054

0.086

0.609

0.408

0.422

0.183

0.050

0.655

SFAS 87 and SFAS 88

0.403

0.215

0.052

SFAS 94

0.420

0.174

SFAS 106, 109, and 115

0.289

SFAS 121 and 123

Difference
Common

BS Only

IS Only

Combined

0.652

-0.045

0.140

-0.066

0.029

0.063

0.656

-0.063

0.165

-0.040

0.062

0.206

0.056

0.670

-0.061

0.152

-0.030

0.061

0.368

0.221

0.061

0.650

-0.054

0.038

0.011

-0.005

0.670

0.289

0.286

0.059

0.634

-0.114

0.071

0.007

-0.036

0.058

0.652

0.276

0.307

0.052

0.635

-0.144

0.133

-0.006

-0.017

0.286

0.059

0.634

0.274

0.156

0.050

0.480

-0.015

-0.130

-0.009

-0.154

0.294

0.296

0.045

0.635

0.124

0.220

0.036

0.380

-0.170

-0.076

-0.009

-0.255

SFAS 133

0.274

0.156

0.050

0.480

0.303

0.278

0.063

0.644

0.029

0.122

0.013

0.164

SFAS 141, 142, and 144

0.209

0.157

0.049

0.415

0.397

0.191

0.095

0.683

0.188

0.034

0.046

0.268

Mean all standards

0.371

0.159

0.067

0.597

0.325

0.224

0.059

0.608

-0.045

0.064

-0.008

0.011

1.41

2.05 *

0.81

0.25

t-statistic

* / ** / *** significant at the 0.10 / 0.05 / 0.01 level.

38

Combined