Accounting Restatements: Malfeasance and/or Optimal Incompetence?

While accounting research often uses restatements as a measure of earnings quality (EQ), often overlooked is the explicit recognition that EQ arises endogenously as a by-product of the firm’s value-maximizing investment in accounting resources. This paper develops a model of restatements that incorporates both the optimal investment in accounting systems (i.e., “optimal incompetence”) and incentives to intentionally misrepresent the firm’s financial performance (i.e., “malfeasance”). Our framework predicts that smaller, financially weaker firms will optimally invest less in accounting resources than their larger, more profitable counterparts. To identify our reduced-form empirical model, we propose two novel measures of the firm’s investment in accounting systems: filing timeliness of the firm’s 10-K and spelling errors in the 10-K. Our empirical results validate the predictions of the model. First, larger and more profitable firms are associated with greater accounting resources. Second, accounting resources are negatively associated with the likelihood of a restatement in the subsequent year. Third, including accounting resources in the restatement prediction model diminishes the explanatory power of covariates identified in prior studies as capturing misreporting incentives, especially in the case of restatements flagged as irregularities (i.e., fraud). In cross-sectional tests, we find that the association between accounting resources and future restatements is stronger during booms as compared to downturns – which questions prior inferences on the role of the business cycle on accounting fraud. Our results are robust to controlling for the endogeneity of accounting resources using an instrumental design that exploits regulatory changes in firms’ filing deadlines. ______________________________________________________________________________ We thank Jeff Burks (discussant) and workshop participants at the Duke/UNC Fall Camp, MIT Sloan School of Management, SMU, and the UIUC Young Scholars Conference for helpful comments.