Principle-Based Standards and Analyst Forecasts: Evidence from China

Synopsis The research problem This paper investigated the impact of principle-based accounting standards on analyst forecasts. Motivation The theoretical and practical debates over whether accounting standards should be more principle-based or rule-based have persisted to this day. Existing research primarily focused on the impact of principle-based standards on managers, auditors, and investors in developed economies. However, whether principle-based standards have played the anticipated positive role in emerging markets with relatively weaker institutional environments—and particularly, how they affect another important participant in financial markets, namely, analysts—is the research gap we wished to further explore. The test hypotheses We tested the following hypotheses: (a) principle-based accounting standards are associated with higher analyst forecast errors; (b) managers’ earnings management incentives and a weak institutional environment exacerbate the negative impact of principle-based standards on analyst forecasts; and (c) analysts’ limited attention and effort aversion exacerbate the negative impact of principle-based standards on analyst forecasts. Target population Financial analysts, accounting standards setting bodies such as IASB and accounting regulators in emerging markets. Adopted methodology We used ordinary least squares regressions, archival data, and textual analysis methods to obtain the initial data. Analyses First, based on firms’ annual reports, we used text analysis methods to construct a firm-level principle-based measurement. Then, we examined the relationship between the degree of a firm’s reliance on principle-based standards and the analyst forecast errors. After obtaining the baseline result, we further discussed the possible mediating effects of accounting information quality and analysts’ subjective mindsets. Finally, we discussed the impact of principle-based standards on other forecasting attributes beyond analyst forecast errors. Findings Using a sample of Chinese listed firms, we found that analysts’ forecast errors are larger for firms that rely more on principle-based standards. Based on the “input-processing-output” model, we found that in the input stage, principle-based standards may become a tool for managers to manipulate accounting earnings in firms with stronger earnings management incentives or that are in weaker institutional environments, leading to higher analyst forecast error, with accounting information quality as an important mediator. During processing, analysts’ limited attention and effort aversion exacerbate the adverse impact of principle-based standards on forecast quality, while analysts’ experience can mitigate this effect. For output results, principle-based standards are also associated with higher forecast dispersion, longer forecast lag, and more forecast revisions. Collectively, our research uncovered some dark sides of principle-based standards in weak institutional environments.