The paper by Bertomeu and Magee (this issue) endogenizes accounting regulation by a majority-seeking regulator and examines how the economic cycle affects mandatory reporting quality. This discussion puts the paper in the broader context of a theory of accounting regulation. Then, it focuses on crucial assumptions, including the exogenous evolution of the economy, the role of market frictions, the modeling of reporting quality, and the regulatory process and regulatory cycles, and provides suggestions for future research.

This paper analyzes voluntary disclosure strategies of a privately informed firm when the information is relevant for the market price of the firm and also for an opponent. Favorable information increases the market price but might induce the opponent to take a discrete action that imposes proprietary costs on the firm. It is shown that there is always a full-disclosure equilibrium. There can exist partial-disclosure equilibria with two nondisclosure intervals. Comparative statics show some counter-intuitive results, e.g., higher proprietary costs or higher risk of an adverse action can make disclosure of favorable information more or less likely.

We study the optimal accounting policy of a financially constrained firm that pledges assets to raise debt capital for financing a risky project. The accounting system provides information about the value of the collateral. Absent accounting regulation, the optimal accounting system is conditionally conservative: it recognizes an impairment loss if the asset value is below a certain threshold, but never reports unrealized gains. We describe the optimal impairment rule and the optimal precision of the accounting information, and we provide comparative static results that lead to testable predictions on the determinants of impairment rules.

Securities regulators frequently punish firms for their managers’ misreporting. They argue that this would enhance firms’ long-term value by mitigating underinvestment in compliance mechanisms, such as internal controls over financial reporting. Opponents of corporate penalties argue that the penalties would harm the very same investors already harmed by misreporting. We evaluate these arguments in a model with a capital market-oriented misreporting manager and a board of directors that invests in internal control quality. We identify governance transparency and board dependence as key factors that moderate the firm-value effects of corporate penalties. Internal control underinvestment occurs only if the board is severely dependent and if its choice of internal controls is opaque. Then corporate penalties curb internal control underinvestment, but they only improve long-term firm value if, additionally, internal control costs are sufficiently small (e.g., in small and less complex firms). Overall, our differentiated results have implications for regulatory enforcement policies and empirical studies on the firm-value effects of public enforcement.

Empirical studies on the relationship between shareholder litigation and corporate disclosure obtain mixed results. We develop an economic model to capture the endogeneity between disclosure and litigation. Equilibrium disclosure is determined by two countervailing effects of litigation, a deterrence effect and an insurance effect. We derive four key results. (i) Decreasing litigation risk leads to less disclosure of very bad news, due to a weakening of the deterrence effect, but to more disclosure of weakly bad news, due to a weakening of the insurance effect. (ii) Given a sufficiently large information asymmetry, litigation risk dampens (boosts) overall disclosure of bad news for low (high) litigation risk firms. (iii) Capital markets respond more to the disclosure of bad news than of good news if the deterrence effect is strong, which arises if both insiders’ penalties and litigation risk are high. (iv) In an extension, we highlight real effects of litigation on corporate innovation and establish that innovation first decreases and then increases (strictly decreases) with litigation risk if insiders’ penalties are small (large). We reconcile our findings with results from a large set of U.S.-based empirical studies and make several novel predictions.

Although internal control over financial reporting has gained increasing regulatory attention, its enforcement is far from perfect; thus, firm‐specific incentives to management become important to increase the quality of financial reports. We study how owners can motivate managers to invest in accounting quality even though it is costly to the managers. Using an agency model, we establish that a sufficiently conservative accounting system (which understates performance) is necessary to induce a manager to invest in accounting quality, and more conservatism increases this investment. The reason is that higher accounting quality mitigates the expected reduction of the manager's compensation from conservatively measured performance. Higher accounting quality makes the performance measure more precise, and the owner optimally lowers incentives, even though that entails some loss of productivity. In total, more conservatism increases both firm value and accounting quality. Our findings suggest that striving for neutral accounting can counteract incentives to improve accounting quality, and they provide support to using conservatism as a metric of financial reporting quality in empirical studies.

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.

This paper studies strategic interactions between public and private enforcement of accounting regulation and their consequences for the deterrence of financial misreporting. We develop an economic model with a manager, a public enforcement agency, and an investor and derive equilibrium strategies for manipulative effort, routine investigative effort, and costly private litigation. Our main results are as follows. (i) Strengthening private enforcement unambiguously enhances deterrence, whereas strengthening public enforcement can exacerbate misreporting, due to a crowding out of private enforcement. We provide conditions under which (ii) the enforcer's investigation incentives first increase and then decrease in the strength of private enforcement, (iii) public and private enforcement are strategic substitutes, (iv) the number of enforcement actions is misleading about public enforcement effectiveness, and (v) strengthening private enforcement decreases litigation risk. We also discuss implications of our results for empirical research.

This paper examines the usual claim that tighter accounting standards reduce earnings management and provide more relevant information to the capital market. We distinguish between accounting and real earnings management and assume that a standard setter can only influence accounting earnings management by the tightness of standards. In a rational expectations equilibrium model, we find that earnings quality increases with tighter standards, but we identify several consequences that may outweigh this benefit. First, managers increase costly real earnings management because the higher earnings quality increases the marginal benefit of real earnings management. Second, tighter standards can increase rather than decrease expected accounting and total earnings management. Third, the expected total costs of earnings management can also increase. We provide conditions for the occurrence of each of these effects.