Toward a Positive Regulatory Enforcement Theory of Financial Reporting

This paper develops a theory in which regulatory enforcement and investments are jointly determined by economic fundamentals. Enforcement disciplines misreporting of investment outcomes, which reduces reporting biases as well as market discounts, benefiting entrepreneurship. However, a government has limited commitment and thus implements an economically viable enforcement regime after investments become observable. A larger market justifies the more effective albeit costly regime. Hence, entrepreneurs collectively have incentives to overinvest to induce excessive enforcement as a public good. However, a larger market requires them to coordinately invest more. The strategic uncertainty about the others' investments leads to uncertainty about the future regime. If the economic environment is not conducive to the expectations of an effective future regime, the market can be under-sized and under-regulated. The theory further suggests that the empirical association between enforcement and market development does not infer a simple one-way causal relationship