Does Economic Policy Uncertainty Matter for Financial Reporting Quality? Evidence from the United States

We examine the effect of economic policy uncertainty (EPU) on the financial reporting quality of US firms over 1999-2015. Using accruals-based earnings management as a proxy for financial reporting quality and the index of Baker et al. (2016) as an EPU measure we show that they exhibit a positive and significant association in accordance with the “lean against the wind” hypothesis. We also find a causal effect by employing the recently developed index of partisan conflict in the US Congress of Azzimonti (2018) as an instrument for EPU. In a cross-sectional analysis, we further show that the positive relationship between EPU and earnings management strengthens for riskier firms and firms belonging to politically sensitive industries. Overall, these results indicate that managers aim to provide outsiders with an improved financial picture of the company when EPU is high. These findings suggest that investors and regulators should be wary of firms' financial reporting quality in periods of high economic policy uncertainty