This paper examines the usual claim that tighter accounting standards reduce earnings management and provide more relevant information to the capital market. We distinguish between accounting and real earnings management and assume that a standard setter can only influence accounting earnings management by the tightness of standards. In a rational expectations equilibrium model, we find that earnings quality increases with tighter standards, but we identify several consequences that may outweigh this benefit. First, managers increase costly real earnings management because the higher earnings quality increases the marginal benefit of real earnings management. Second, tighter standards can increase rather than decrease expected accounting and total earnings management. Third, the expected total costs of earnings management can also increase. We provide conditions for the occurrence of each of these effects.

We examine whether the design of a firm’s internal management accounting system is associated with GAAP earnings management. We exploit the fact that ASC 280 mandates a “management approach” requiring multisegment firms to disclose their segment earnings as defined internally by their management accounting system. We posit that the less these segment earnings are decoupled from GAAP earnings, the higher are the costs of earnings management because earnings management spills over to segment earnings and distorts information used for internal decision-making. Thus, we predict that firms with more decoupled segment earnings engage in more earnings management. Using a large sample of U.S. firms from 1998 to 2020, we find support for this prediction. We also find that the decision usefulness of segment earnings for segment investment purposes decreases as earnings management increases, with this association being more pronounced for firms with less decoupled segment earnings measures. Data Availability: Data are available from the public sources cited in the text.