Imperfect Accounting and Reporting Bias

Abstract

Accounting is imperfect, leading to errors in financial reporting. This paper links accounting errors to firms’ incentives to bias reported earnings. We hypothesize that while errors discourage reporting bias by lowering earnings’ value relevance, they also incentivize bias by providing camouflage. Consistent with the counteracting effects, we document a hump-shaped relationship between an industry’s incidences of intentional and unintentional misstatements, our primary proxies for reporting bias and errors. This finding is robust to using several alternative proxies. To further validate the two effects, we show that, when errors are more prevalent, the market reacts less to firms’ earnings surprises, and fraud is more difficult to detect. Our findings highlight the imperfectness of accounting and shed light on accounting standard setting.

Keywords: Financial Fraud; Accounting Errors; Restatements; Earnings Response Coefficient; Fraud Detection; Principles-Based Accounting Standards; Rules-Based Accounting Standards

JEL Classification: G32; G34; G38; M40; M41; M48; M53