Capital Allocation Effects of Financial Reporting Regulation and Enforcement

Abstract

This paper analyses the effects of stricter financial reporting enforcement on capital allocation and reporting quality in a game-theoretic model and derives conclusions about optimal enforcement strictness. Analysis of the model shows that reporting quality strictly increases with tighter enforcement. However, the effect of stricter enforcement on capital allocation is non-monotonic. Intermediate enforcement strictness results in overdeterrence of viable projects even without costs of compliance. This effect can be alleviated by means of either less or more stringent enforcement.

Acknowledgements

Helpful comments by Jonathan Glover, Markus Mädler, Alfred Wagenhofer and participants of a research forum at the EAA Annual Congress in Rotterdam and the Workshop of Accounting and Economics in Milan are gratefully acknowledged.

Notes

Arya et al. (1998) classify earnings management models by the assumption of the Revelation Principle that they violate. In our model, capital market participants cannot commit not to use information about misreporting when determining a market price. This therefore violates the condition of the possibility of unlimited commitment.

Since market prices are derived using Bayesian revision of expectations b = 1, that is, always reporting success, leaves P _F undefined. However, assuming that (1) also holds in this case is the only belief fulfilling the intuitive criterion (Cho and Kreps, 1987). A related discussion can be found in Korn and Schiller (2003).

Additional information

Notes on contributors

Roland Königsgruber

Paper accepted by Salvador Carmona.