Measuring Misreporting Incentives and Severity

We propose an empirical measure of the types of financial misreporting based on misreporting incentives. We identify three distinct types: (1) misreporting driven by top executives’ wealth pursuits, (2) misreporting induced by capital market pressure, and (3) misreporting by subordinates due to inadequate management oversight. Our measure is developed by conducting a detailed analysis of the textual data from SEC Accounting and Auditing Enforcement Releases (AAERs). We also provide rigorous empirical validations. Additionally, we create a composite misreporting severity score that incorporates the three misreporting incentives. Using our measure of misreporting incentives, we help reconcile previous mixed findings on the link between equity incentives and financial misreporting. Furthermore, in predicting market reactions to misreporting, our misreporting severity score outperforms a measurement that does not integrate misreporting incentives. Our measures can be practical
tools for investigating a wide range of research questions related to the causes and consequences of financial misreporting.