Accounting Standard Precision, Corporate Governance, and Accounting Restatements
59 Pages Posted: 27 Feb 2018 Last revised: 20 Apr 2018
Date Written: April 11, 2018
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 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 standard precision caused by 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 PBS strengthen the positive relationship between executive equity incentives and restatements, but weaken the monitoring effectiveness of independent boards, audit committees, external auditors, and financial analysts at constraining financial misreporting. 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 internal and external corporate governance mechanisms currently in place may not function as well under more PBS as under more RBS, potentially reflecting that it is harder to enforce less precise accounting standards. Our results have important policy implications to the current debate on moving the U.S. financial reporting regime toward a more principles-based framework.
Keywords: Accounting Standards, Restatements, Corporate Governance
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