Accounting Standard Precision, Corporate Governance, and Accounting Restatements.

• In Event: Accounting Standards and Audit Quality

Abstract

Prior research documents wide variation in the precision of accounting standards (rules-based versus principles-based accounting standards). We examine whether financial reporting quality evident in restatements is associated with accounting standard precision and whether the role that various internal and external monitors play in the financial reporting process varies with accounting standard precision. Our strong, robust evidence implies that the likelihood of a subsequent financial report restatement decreases as the accounting standards applicable to the firm become more principles-based. This inference is robust to examining exogenous shifts in accounting standard precision caused by accounting standard revisions. Additional analyses suggest that our evidence mainly stems from managers’ concern over second guessing, rather than greater litigation risk or greater auditor effort when managers have more latitude under the more principles-based standards (PBS). We also find that independent boards and audit committees, external auditors, and financial analysts are more effective at constraining financial misreporting at firms relying more on rules-based accounting standards (RBS) than firms relying more on PBS. Our large-sample empirical evidence suggests that U.S. firms, on average, do not exhibit a greater incidence of financial misreporting under PBS where managers have greater latitude and exercise more professional judgment in the accounting treatment of economic events. However, some of the internal and external corporate governance mechanisms currently in place may not function as well under more PBS as under more RBS. Our results have important policy implications to the current debate on moving the U.S. financial reporting regime toward a more principles-based framework.

Authors

• Li Fang, Iowa State University

• Jeffrey Pittman, Memorial University of Newfoundland

• Yinqi Zhang, American University

• Yuping Zhao, University of Houston-Houston