"Deterrence of financial misreporting when public and private enforcement strategically interact” (JAE)

In this article, published in the August issue of the Journal of Accounting and Economics (JAE), CAR’s Alfred Wagenhofer and Stefan Schantl (University of Melbourne and former DART student) study strategic interactions between public and private enforcement of accounting regulation and their consequences for the deterrence of financial misreporting. They 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. The main results of the model are that strengthening private enforcement unambiguously enhances deterrence, whereas strengthening public enforcement can exacerbate misreporting, due to a crowding out of private enforcement. They provide conditions under which the enforcer's investigation incentives first increase and then decrease in the strength of private enforcement, public and private enforcement are strategic substitutes, the number of enforcement actions is misleading about public enforcement effectiveness, and strengthening private enforcement decreases litigation risk. Lastly, the model discusses empirical implications.