Effects of Increasing Enforcement on Financial Reporting Quality and Audit Quality
62 Pages Posted: 28 Jul 2016 Last revised: 18 Nov 2018
Date Written: November 17, 2018
A widely held assumption in policy making and empirical research is that increasing the strength of public enforcement improves financial reporting quality and audit quality. This paper provides a more nuanced view. In a model with a manager who can manage earnings, a strategic auditor, and an enforcement institution, we show that enforcement and auditing are complements in a weak enforcement regime but can be substitutes in a strong regime. Although stronger enforcement always mitigates earnings management, the effects of different instruments of strengthening enforcement are ambiguous. We show that they can improve or impair financial reporting quality and audit quality, depending on production risk, accounting system characteristics, and the scope of auditing relative to enforcement.
Keywords: Earnings Management, Enforcement, Auditing, Financial Reporting Quality, Audit Quality
JEL Classification: G38, M41, M42, M48
Suggested Citation: Suggested Citation