Three essays on standards and the capital market

This thesis consists of three essays in the area of standards and the capital market. Essay 1 studies the effect of a move towards principles-based accounting standards on price efficiency in the equity market. I find that the effect on price efficiency is non monotonic. When standards are highly rules-based, reducing the use of rules-based standards increases price efficiency. However, at some point, this relation reverses. In addition, expected earnings management in financial statements is also non-monotonic in the use of rules-based standards. Finally, I find that higher managerial compensation incentives require more rules-based standards for price efficiency to be maximized.; Essay 2 discusses the optimal level of earnings management deterrence needed in regulation. I assume standards are "bright line" and binary, such that a certain financial item could be categorized in one of two categories (for example, capital vs. operational lease, consolidate vs. not to consolidate, etc.). I find that an increase in the level of deterrence may well be counter-productive, decreasing the informational value of financial reporting as well as increasing total social welfare costs of earnings management. I also analyze extensions to the basic model where standards are sticky (and sub-optimal), when the value of financial items is measured with possible measurement errors and when manipulation of real activities (real earnings management) is also available for managers.; Essay 3 deals with the economic effects of enriching the auditors' opinions choice set. The paper introduces the possibility for an intermediate audit opinion between the qualified and the unqualified opinions, or "aggressive accounting" opinion. In choosing the right audit opinion I show that the auditor trade-offs potential litigation costs on the one hand and the value of the audit, which determines the audit fee, on the other hand. I find that the move towards a richer choice set of audit opinions will always increase the informative value of the audit in equilibrium and increase auditors' profit, and thus will be beneficial to all market participants: auditors, investors and firm owners. However, it also increases the frequency of auditors' litigation and may in some situations increase their expected litigation cost.