Economic Effects of Public Enforcement When Both Managers and Firms Are Penalized for Misreporting

Abstract

Empirical evidence on the capital market effects of public enforcement is mixed. We present a theory to provide a possible explanation for this mixed evidence. In our model, a myopic owner-manager engages in financial misreporting with both valuation and real effects. Firms initially establish internal controls (ICs) over financial reporting to prevent misreporting, leading to compliance costs that reduce firm value. A regulator investigates firms with a given intensity and, upon detecting misreporting, imposes penalties on both managers and firms. We show that corporate penalties incentivize firms to manage their regulatory exposure by investing in IC quality, mitigating managerial misreporting incentives and improving financial reporting quality and investment efficiency. Managerial penalties induce a direct deterrence effect that mitigates misreporting incentives but also crowd out IC quality. This effect can be so strong that financial reporting quality and investment efficiency decrease. Firms' compliance costs can increase or decrease, and we show that they are the key driver for changes in firm value, even in the presence of real effects. In particular, strengthening public enforcement improves (impairs) firm value if managerial penalties are large (small). We also show that, while corporate penalties are detrimental to investor welfare, they are socially beneficial as long as they are not exorbitant. These nuanced results should be helpful for guiding empirical studies and capital market regulation.

Keywords: financial reporting quality, accounting manipulation, cost of capital, public enforcement, corporate penalties

JEL Classification: G39, K22, K42, M41