Why More Forward-Looking Accounting Standards Can Reduce Financial Reporting Quality

A premise of standard setters and of much empirical research is that improving the quality of accounting standards and their implementation increases information in capital markets. This paper challenges this premise and shows that there are situations in which ‘better’, that is, more forward-looking, accounting standards reduce the information content of financial reports. The reason is that a forward-looking accounting standard affects the smoothness of reported earnings, which can conflict with the manager's smoothing incentive and her willingness to incorporate private information in the financial report. Although the manager could eliminate the effect by earnings management, it is too costly to do so. As a consequence, the capital market's ability to infer the financial and nonfinancial information in reported earnings declines. This finding should increase the awareness that an ‘improvement’ in accounting standards, without considering incentives and other information residing in firms, can adversely affect the quality of financial reporting.