A Bayesian approach for predicting material accounting misstatements

Feng Xu and Zinan Zhu

Asia-Pacific Journal of Accounting & Economics, 2014, vol. 21, issue 4, 349-367

Abstract: In this paper, we develop prediction models of material accounting misstatements in a Bayesian framework. Outputs of the Bayesian approach are probabilistic descriptions for the propensity of conducting an accounting misstatement and for a riskiness comparison across different companies. The models are applied to a comprehensive sample of firms that have been subject to enforcement actions by the Securities and Exchange Commission for allegedly misstating their financial statements between 1982 and 2005. The results suggest that while maintaining a comparable Type-I error, out-of-sample predictions of the Bayesian models improve in terms of sensitivity and the Type-II error. This study provides a useful tool to assess material accounting misstatement risks.

Date: 2014
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DOI: 10.1080/16081625.2014.946063

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Asia-Pacific Journal of Accounting & Economics is currently edited by Yin-Wong Cheung, Hong Hwang, Jeong-Bon Kim, Shu-Hsing Li and Suresh Radhakrishnan

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