Financial Reporting Regulation: Intended and Unintended Consequences

Financial reporting regulation can improve allocation of resources and facilitate capital formation, but lack of observability may hide both intended and unintended consequences of regulatory design choices. In this paper, we explore some of the implications of regulated financial reporting with respect to the objectives of investor protection and capital formation, uncovering intended and unintended consequences. Our analysis yields three main results. First, investor perception of financial reporting quality, that reflects observable investment outcomes, varies with the state of the economy. Thus, in an economic bust, observable investment failures lower investor perception of financial reporting quality causing investors to demand regulatory intervention. Second, while more stringent implementation standards enhance investor protection, they hinder capital formation. Third, better measurement criteria can simultaneously enhance investor protection and capital formation, even if implementation is somewhat worse. These results have implications for evaluating accounting and auditing regulators’ performance in balancing competing objectives and overseeing separate accounting and auditing standards setters.