Accounting Standard Precision, Monitoring Structure, and Misreporting

• In Event: Regulation and Monitoring

Abstract

Prior research documents wide variation in the precision of accounting standards (rules-based standards (RBS) versus principles-based standards (PBS)). We examine whether financial reporting quality evident in restatements is associated with accounting standard precision and whether the role that non-regulatory monitors and the SEC as the regulator 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 standard precision arising from accounting standard revisions. Additional analyses suggest that our evidence mainly stems from managers’ concerns over second guessing rather than greater litigation risk. We also find that non-regulatory monitors, including independent boards, audit committees, and external auditors, play a more effective role at constraining misreporting when they have the guidance of more detailed rules under RBS, whereas the SEC plays a more prominent role when there is a lack of clear guidance under PBS. Our large-sample empirical evidence suggests a potential trade-off between PBS and RBS: although the average reporting quality measured by misreporting may improve under the more principles-based framework, some of the corporate governance mechanisms carried out by non-regulatory monitors may not function as well under more PBS as under more RBS, potentially reflecting that it is harder for non-regulatory monitors to enforce less precise accounting standards. Contributing to the current policy debate, our results suggest that more intensive regulatory monitoring would be needed to compensate for the potentially weakened monitoring by non-regulatory monitors should the U.S. financial reporting regime move to 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