The Selective Financial Misrepresentation Hypothesis

Financial reporting rules in both the private and public sector are often arbitrary, complicated, and misleading. The incentives that motivate various parties to misrepresent financial events are examined. For example, the selective misrepresentation hypothesis argues that managers prefer reporting methods that provide latitude in income determination rather than methods that tightly specify statement numbers under given economic conditions. By providing managers with control over when they can report externally driven events, loose reporting standards can be used by managers to increase compensation and to hide perquisite consumption, incompetence, or laziness. Improving public sector financial reporting standards requires a 4-step process: 1. educating the public, 2. improving the process for selecting and monitoring standard setters, 3. establishing new funding arrangements, and 4. creating independence for the standard setters. Since market forces anticipate and ameliorate elements of the private sector wealth transfers, refinement of reporting rules in that sector seems less urgent.