We analyze the reporting strategies of firms and the investigation strategies of auditors in an archetype principles-based financial reporting system. To this end, we add a verification stage to a standard cheap-talk game, and apply the resulting game to financial reporting. We show that for a principles-based system to work properly, firms should bear a sufficient share of the cost of a thorough investigation. Furthermore, we find that a principles-based system is a mixed blessing. On the one hand, it leads to a plausible investigation strategy of the auditor, in which "suspected" reports receive most attention. On the other hand, a principles-based system only indirectly weakens firms' incentives to report aggressively.

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Tinbergen Institute
Tinbergen Institute Discussion Paper Series
Discussion paper / Tinbergen Institute
Erasmus School of Economics

Bijkerk, S.H, Karamychev, V.A, & Swank, O.H. (2013). Aggressive Reporting and Probabilistic Auditing in a Principles-Based Environment (No. TI 13-131/VII ). Discussion paper / Tinbergen Institute (pp. 1–44). Tinbergen Institute. Retrieved from http://hdl.handle.net/1765/41255