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Financial reporting, regulation and information asymmetry

Mengcherng Deng, 2007
Faculty Advisor: Tim Baldenius
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The thesis analyzes how regulators can design financial reporting system in order to mitigate the effect of information asymmetry. First consider an entrepreneur, having private information about the prospect of an investment project, seeks to raise capital from an investor. A noisy accounting signal that is correlated with the prospects of the investment and thus useful for the investor in contracting with the entrepreneur. The inefficiencies in the legal system reduce the investment efficiency and thus the value of the contracting relationship. A regulator may adopt a principles-based system in order to balance the inefficiencies in the legal system against the informativeness of the reporting system. Second, consider an entrepreneur who can exert costly effort to improve the project profitability. An auditor observes an ex ante accounting signal correlated with future unrealized project profitability. A regulator may adopt ex ante conservatism to balance the ex ante incentive of inducing the entrepreneur's effort against the ex post investment efficiency. The higher the value of the project, the less the regulator prefers to conservative reporting. In contrast, when agency costs increase, accounting policy becomes more conservative.


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