Corporate Monitoring and Misreporting: The Role of Rules-based and Principles-based Accounting Standards

Abstract

Prior research provides some evidence that strict corporate monitoring constrains financial misreporting. We examine whether the efficacy of various corporate monitoring mechanisms depends on the nature of accounting standards―rules-based standards (RBS) versus principles-based standards (PBS)―in place. We document that most features associated with tough monitoring by audit committees, boards, external auditors, and the Securities and Exchange Commission (SEC) are negatively associated with the likelihood of misstatements under RBS, but not misstatements under PBS. This evidence collectively suggests that most corporate gatekeepers likely fulfill their monitoring obligations primarily through ensuring better compliance with detailed standards when the applicable standards are more specific and leave less room for discretion. In contrast, our results imply that corporate monitors may fail to effectively constrain managerial opportunism when the standards are less specific and provide wider scope for discretion. We also find that misstatement duration decreases with strict monitoring under RBS, suggesting that timely detection is a channel through which corporate monitoring deters violations of RBS. Our core evidence is robust to using exogenous shocks to certain corporate monitoring functions mandated by the Sarbanes Oxley Act and stock exchanges. Relevant to the public policy discourse, our results lend some support that there is an institutional fit between the current corporate monitoring structure and rules-oriented accounting standards, while casting doubt on whether current corporate monitoring mechanisms would function effectively in the event that the U.S. financial reporting regime moves to a more principles-based framework.

Keywords: Accounting Standards, Restatements, Corporate Governance