Ewert2018 PDF

Effects of Increasing Enforcement on
Financial Reporting Quality and Audit Quality
RALF EWERT* AND ALFRED WAGENHOFER*
*
University of Graz.
Accepted by Haresh Sapra. We thank an anonymous reviewer, Hans Christensen, Pingyang Gao, Ian
Gow, David Grünberger, Trevor Harris, Bjorn Jorgensen, Sebastian Kronenberger, Peter Pope, Joshua
Ronen, Stefan Schantl, Ulf Schiller, Cathy Schrand, participants at the GEABA Conference in
Hamburg, NYU Accounting Summer Camp, EIASM Workshop on Accounting and Regulation, IWP
Wissenschaftsforum, and seminar participants at Columbia University, University of Würzburg,
University of Cluj, London School of Economics, University Carlos III Madrid, University of Chicago,
University of North Carolina at Chapel Hill, London Business School, WHU – Otto Beisheim School of
Management, University of Chile, and University of Melbourne for helpful comments.
November 2018
Abstract
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.
JEL codes: G38; M41; M42; M48
Keywords: earnings management; enforcement; auditing; financial reporting quality; audit quality.
This article has been accepted for publication and undergone full peer review but has not been
through the copyediting, typesetting, pagination and proofreading process, which may lead to
differences between this version and the Version of Record. Please cite this article as doi:
10.1111/1475-679X.12251.
This article is protected by copyright. All rights reserved.

1. Introduction
Enforcement is an important element of the institutional framework that assures the quality of
financial reporting by listed companies. Empirical studies show that effective enforcement is as
crucial for efficient capital markets and is perhaps even more important than the quality of the
accounting standards themselves (e.g., Ball, Kothari, and Robin [2000], Christensen, Hail, and Leuz
[2013]). Most developed countries have established enforcement institutions, including the SEC’s
Division of Corporation Finance in the United States and national enforcement agencies in European
Union countries, which are coordinated and overseen by the European Securities and Markets
Authority (ESMA). The effectiveness of enforcement differs widely around the world (Brown,
Preiato, and Tarca [2014]), and regulators strive to improve it to foster capital market efficiency
(e.g., SEC [2000], EU [2004]).
A widely held assumption in policy making and empirical research is that greater enforcement is
desirable because it improves financial-reporting and audit quality, and several empirical studies
provide supporting evidence.1 Under this view, primarily the direct costs of enforcement limit its
desirability. Recent papers by Christensen, Liu, and Maffett [2017] and Florou, Morricone, and Pope
[2018] find support for high costs of enforcement to firms, exploiting a change of the enforcement
by the Financial Reporting Review Panel in the United Kingdom. Christensen, Liu, and Maffett [2017]
find that stronger enforcement reduces shareholder wealth. Florou, Morricone, and Pope [2018]
document that stronger enforcement increases audit effort, risk, and fees, particularly for firms
listed on the Alternative Investment Market.
The view that greater enforcement improves financial-reporting and audit quality implicitly is correct
if one assumes that it does not alter the auditor’s strategy. Once one considers direct and indirect
effects, the results can be different. Our paper analyzes the effects of stronger enforcement on
earnings management, financial-reporting and audit quality, and audit fees in an equilibrium setting.
We develop a model in which the owner of a firm hires a manager and a strategic auditor. The
compensation contract designed to motivate the manager to provide productive effort also creates
incentives for upward earnings management. The auditor strategically chooses an effort that
identifies and corrects errors in the preliminary financial report, based on a conjecture of earnings
management and enforcement outcomes. After publication of the audited financial report, the
enforcer investigates. It identifies remaining errors with some probability (the enforcement
intensity) and imposes penalties on the owner, manager, and auditor. Stronger enforcement is
achieved by increasing enforcement intensity or any of the penalties inflicted to the parties.
Our main finding is that auditing and enforcement are complements in a low-intensity enforcement
regime but can become substitutes in a strong regime. The auditor’s incentives to perform a high-
1
See Hope [2003], Ernstberger, Stich, and Vogler [2012], Christensen, Hail, and Leuz [2013], Brown, Preiato,
and Tarca [2014], and Silvers [2016].

quality audit increase with greater enforcement, because the expected penalty rises, and they
decrease with lower anticipated earnings management. In a low-intensity enforcement regime, the
direct effect, through the rise in the expected penalty dominates. In contrast, in a strong regime, the
reduction of earnings management dominates, so that the auditor lowers audit effort. We show
that, even if enforcement crowds out audit effort, earnings management always declines with
enforcement intensity. In contrast, strengthening enforcement, through increasing the penalties on
the manager or auditor, strictly mitigates earnings management. A higher penalty on the auditor
increases audit effort, whereas a higher penalty on the manager does the opposite, because it
discourages earnings management. Endogenizing the compensation contract, we show that the
owner benefits from stronger enforcement, because she can reduce incentive compensation, which
alleviates the manager’s incentives to manage earnings, but this effect is small, relative to the direct
effects.
We use the equilibrium strategies to examine the effects of strengthening enforcement on financial
reporting quality and on audit quality in equilibrium. Our results suggest that the effects depend on
the proxy for financial reporting quality. If it measures intentional errors only, as does the modified
Jones model (Dechow, Sloan, and Sweeney [1995]), then stronger enforcement always increases
financial reporting quality, because it mitigates earnings management. If it measures both
unintentional and intentional errors, as does the Dechow and Dichev [2002] model, then the impact
of stronger enforcement on financial reporting quality depends on the accounting system and the
production environment. The reason is that the accounting system is not perfect and produces
errors that lead to an understatement or overstatement of economic earnings. Through upward
earnings management, the manager makes more overstatements but fewer understatements. If the
corrective function of earnings management on average prevails, deterring it through stronger
enforcement reduces financial reporting quality. Another reason why financial reporting quality can
decline occurs if auditing is broader in scope than enforcement. If enforcement crowds out audit
effort, then the auditor produces less useful information, which decreases financial reporting
quality.
Audit quality can increase or decrease with stronger enforcement. An increase in enforcement
intensity or in the auditor’s penalty strictly increases audit quality in a weak enforcement regime but
can decrease it otherwise. There are two effects: a positive direct effect of the higher intensity or
penalty and a negative indirect effect from mitigating earnings management. Which one prevails
depends on the strength of the enforcement. An increase in the manager’s penalty strictly decreases
audit quality, because it alleviates audit effort. We show that audit fees and the number of
enforcement actions strictly increase with a higher enforcement intensity in a weak enforcement
regime, but that either can decrease otherwise. The number of enforcement actions strictly
decreases with higher penalties for the auditor, manager, or both. Yet the functional form of these
two measures does not fully correspond with that of financial-reporting and audit quality,
respectively.
The main empirical implications of our analyses are as follows. We show that different enforcement
instruments have different, sometimes ambiguous, implications on auditor’s behavior, financial

reporting quality, likelihood of enforcement actions, audit quality, and audit fees. If stronger
enforcement can be attributed to an increase of enforcement intensity or a specific penalty, the
implications of an increase in enforcement can be different. This suggests that the use of composite
indices to measure the strength of an enforcement regime2 may result in inconclusive findings,
because the empirical effects depend on the details by which a certain level of an index has been
reached. Moreover, we show that the predictions vary for different financial reporting proxies.
This paper contributes to recognize and better understand the interactions of earnings
management, auditing, and enforcement and on the resulting accounting outcomes, financial
reporting quality and audit quality. We are not aware of other analytical papers that explicitly study
the economic effects of enforcement and the interaction of enforcement and auditing. However,
this paper relates to several streams of literature that examine earnings management and auditing.
The paper’s productive setting relates to studies of production effort and earnings management in
multi-action agency models. For example, Feltham and Xie [1994] model productive effort and
earnings management (“window dressing”), which are simultaneously induced by the same
information system, and provide insights into the properties of an optimal information system in a
LEN setting. Glover and Levine [2018] assume the manager learns the actual outcome before
managing earnings and can only correct a wrong (low) report, thus allowing that earnings
management can be beneficial. In our paper, the manager can also bias a correct report, but
earnings management can still yield benefits on average. Laux and Laux [2009] study management
compensation by the board of directors, which also decides on oversight effort, and show that these
two decisions are related. Bertomeu, Darrough, and Xue [2017] consider production and earnings
management choices and focus on the optimal bias (conservatism) of the underlying accounting
system. Chan [2016] studies the effect of increasing internal controls on earnings management and
auditing. Laux and Stocken [2018] consider a similar setting but focus on the interaction between
accounting standards and enforcement. Enforcement in their model discovers noncompliance with
some probability and imposes a penalty that increases with stronger enforcement. None of these
papers consider auditing and enforcement jointly.
Other models study earnings management in rational expectations equilibria, in which a manager
biases financial reports to increase the market price of the firm (e.g., Fischer and Verrecchia [2000],
Ewert and Wagenhofer [2011] survey this literature). In these models, auditing and enforcement
implicitly drive the cost of earnings management. Königsgruber [2012] addresses enforcement in
such a model, with the added feature that the manager decides on the investment in a risky project.
He finds that stronger enforcement strictly increases reporting quality but may reduce investment
efficiency, due to over-deterrence of investment in viable projects.3 In contrast, we find that
2
See the composite index constructed by Brown, Preiato, and Tarca [2014].
3
Deng, Melumad, and Shibano [2012] find a related result for increasing auditor liability.

reporting quality can decrease; the reason is that we explicitly model the interaction between
auditing and enforcement.
The auditing literature analyzes audit strategies but does not explicitly consider enforcement. Most
of the papers model a strategic auditor, who maximizes expected utility by the choice of audit effort
(e.g., Antle [1982], Baiman, Evans, and Noel [1987]), as we do. Given that contingent audit fees are
not allowed in most jurisdictions, the motivation for auditors to exert effort in these models usually
results from the risk that the auditor may be held liable if an error is uncovered. Our enforcement
mechanism is explicitly based on its interaction with the audit results. Other papers assume that the
liability arises from shareholder litigation. In that case, the cost to the auditor depends on decisions
by shareholders and on the liability regime (e.g., Ewert [1999], Hillegeist [1999]). In a setting in
which the manager is interested in a high market price of the firm, Patterson, Smith, and Tiras [2016]
study how earnings management and audit effort change if the liability of management, of the
auditor, or of both increase. Other auditing literature considers internal controls implemented
before auditing happens (e.g., Smith, Tiras, and Vichitlekarn [2000], Pae and Yoo [2001]). Ye and
Simunic [2017] study the effect of audit oversight and its interaction with the liability regime on
audit effort and audit market structure.
The paper proceeds as follows. Section 2 describes the model and introduce the underlying
production technology, the accounting system, the discretion for earnings management, auditing,
and public enforcement. Section 3 establishes the equilibrium in the earnings management and
auditing game. Section 4 derives effects of varying the strength of enforcement on equilibrium
earnings management and audit effort. Section 5 examines how strengthening enforcement affects
financial reporting quality, number of enforcement actions, audit quality, and audit fees. Section 6
solves for the optimal compensation contract. Section 7 considers extensions to the model, and
Section 8 concludes with empirical implications.
2. Model
We develop a one-period agency model with the owners of a firm, a manager, an auditor, an audit
oversight institution, and an enforcement institution (the enforcer). In the following, we describe
these elements, their relations, and the production and information technology. The notation is
summarized in the appendix.
2.1. Production technology

The firm owns a production technology that requires the productive input of a manager (effort a),
which determines the outcome that accrues to the owner, together with random events that
capture other productive and environmental factors. The outcome can be the future terminal cash
flow or another output that the owner values. It is represented by a monetary amount x, where x 
{xL, xH} and 0 ≤ xL < xH.
We consider a risk neutral owner representing the owners of the firm or the board of directors and
abstract from potential conflicts of interest among different owners or board members. The owner

hires a manager, who is risk neutral and protected by limited liability. The manager chooses a
productive effort a  {aL, aH} and incurs a private cost of 0 for aL and V > 0 for aH. The effort
determines the probability with which low and a high output realize: xH occurs with probability p,
upon high effort aH, and with probability q, upon low effort aL, where 1 > p > q > 0. We assume that
the owner wants the manager to exert high productive effort aH, because otherwise there is no
agency problem. Then the expected productive outcome is (1 – p)xL + pxH.
The manager has a reservation utility of zero and, because of limited liability, the compensation paid
must be positive. We assume that x is not contractible or not observable to the owner and to the
manager by the time the manager receives the compensation. Compensation s() ≥ 0 is written on
the audited financial report r  {rL, rH}. It is easy to see that a contract s(ri) that induces aH must
satisfy s(rL) < s(rH); that is, the owner pays more compensation if the report is good, because rH is
more likely to occur if the manager chose aH. Moreover, because the manager’s reservation utility is
0 and si ≥ 0, there is no need to overpay the manager, so that s(rL ) = 0 and s ≡ s(rH) > 0, which
reflects a simple bonus contract.
2.2. Accounting system

The firm operates an accounting system that produces a signal y { yL , yH } , where yL < yH, which
the manager privately observes. The signal y is a “raw earnings” number. The accounting system
reports the underlying outcome x imperfectly. Let  denote the probability that yL is reported,
although the output is xH (the -error or understatement error), and  the probability yH is reported,
although x = xL (the -error or overstatement error). The two errors are influenced by the underlying
uncertainty about the future outcome, accounting standards, and the quality of the firm’s
accounting processes. The probabilities  and   (0, 1 2) are exogenously given and common
knowledge.
After observing y, the manager can manage earnings and misrepresent the signal to achieve a
financial report m ≠ y. m is the preliminary financial report, which is subject to auditing (see below).
Earnings management includes the choice of probabilities bL ≡ b(yL) and bH ≡ b(yH) with which it is
successful in reporting mi ≠ yi, i = L, H. The cost of earnings management effort is 0 at bi = 0 and
increasing and convex in bi. It captures disutility from, for example, searching for earnings
management opportunities, future disadvantages, loss of reputation, or unethical behavior but not
enforcement penalties that we consider explicitly. We assume a quadratic cost function, vbi2 / 2 ,
where v is a constant scaling factor that is sufficiently high that bi < 1. We show below (Lemma 1)
that this contract induces earnings management only if yL occurs; that is, bH = 0 and bL ≥ 0. Figure 1
summarizes the information flow and indicates out-of-equilibrium strategies by dotted arrows.

Figure 1: Production and information structure
2.3. Auditing
The firm’s financial report is subject to mandatory auditing. The owner hires an auditor at the
beginning of the game. Before contracting, the auditor learns the precision of the accounting system
{, } and uses it to assess the audit risk and plan the audit procedures. After engagement but
before determining audit effort, the auditor receives the manager’s preliminary report m that is
subject to the audit.
The auditor chooses the audit effort, which equals the probability gi, i = L, H, that he observes the
accounting signal y. Providing gi is privately costly to the auditor with a cost of 1
2 kgi2 , where k > 0 is
a parameter that scales the quadratic cost and is sufficiently large to prevent perfect auditing (gi =
1). The audited financial report is as follows.
 yi with probability gi ,
ri   (1)
mi with probability (1  gi ).
The audit market consists of auditors with similar technologies and is competitive. Consistent with
typical audit regulations, we assume the auditor receives a noncontingent audit fee A > 0. In a

competitive audit market, A is the fee under which the auditor expects to break even on the
engagement; that is, A is determined endogenously.4
After accepting the engagement, the auditor’s objective is to minimize the expected cost of the audit
and of a penalty incurred from any remaining uncorrected errors that are uncovered by
enforcement.
2.4. Enforcement
A public enforcement institution independently investigates audited financial reports. Examples are
the SEC’s Division of Corporation Finance in the United States and national enforcement agencies in
European Union countries. A typical feature is that enforcement investigates financial reports of a
sample of firms after they were audited and published. The sample can be strictly random or chosen
based on some patterns ex ante.
We model public enforcement as a technology. An investigation uncovers the signal yj with some
probability f ∈ *0, 1+, which is uncorrelated with the auditor’s effort gi. We refer to f as the
enforcement intensity that is determined by the budget the enforcer has available for investigations.
For example, allocating a higher budget to the enforcer increases f. Without loss of generality, we
cast our analysis directly in terms of f.
If the enforcer detects yi, the investigation ends without a finding if the report ri equals yi (i = L, H);
otherwise the enforcer initiates an enforcement action, which imposes costs on all parties involved.
These costs include fines, penalties, potential legal liability as well as indirect effects, such as a
reputation loss, and they can be monetary or nonmonetary.
The costs of an enforcement action are penalties CO > 0 on the owner (the firm), C M > 0 on the
manager, and CA > 0 on the auditor. We assume these penalties are not excessive. If CO is large, the
owner will always prefer to induce the low effort aL, and the manager’s compensation can be set
independent of y, which provides no earnings management incentives and avoids enforcement
penalties. We assume fC
M
 s to account for the manager’s limited liability and to avoid situations
in which the penalty is so high that the manager never overstates earnings (bL = 0). Since we vary f in
our subsequent analysis, we make the stronger sufficient condition CM ≤ s. A necessary condition for
gi < 1 is fCA/k < 1, and we assume C A / k  1 . Note that the enforcement intensity f and the
penalties CM and CA act as substitutes in determining enforcement strength.
Figure 2 summarizes the sequence of events.
4
The equilibrium we establish does not depend on the competition in the audit market. Once the fee is fixed,
it does not affect the equilibrium strategies.

Figure 2: Timeline
 Owner hires manager and engages auditor
 Manager provides productive effort a
 Manager observes accounting signal y and engages in earnings management b
 Preliminary report m is released
 Auditor chooses audit effort g, learns y with probability g, and corrects errors (m ≠ y)
 Audited report r is published
 Manager receives contractual compensation s(r)
 Enforcer investigates audited report r, learns y with probability f, and initiates enforcement
action if r ≠ y
O M A
 Owner, manager, and auditor suffer penalties C , C , and C respectively from enforcement
action
3. Equilibrium
In this section, we characterize the equilibrium earnings management and auditing strategy given an
incentive-compatible compensation contract. We endogenize the contract in Section 6. All formal
proofs are in the appendix.
The manager chooses bi after observing y = yi to maximize her expected utility, conjecturing the
auditor’s audit strategy gˆ L and gˆ H , where the hat denotes conjectures. The expected utilities are
v
E[U M yL ]  prob(rH yL ) s  prob(error yL )C M  V  bL2 ,
2 (2)
v
E[U M yH ]  prob(rH yH ) s  prob(error yH )C M  V  bH2 .
2
The terms are the conditional expected compensation, the expected enforcement cost, the disutility
of effort aH, V, and the disutility of earnings management. The probabilities depend on the
productive effort aH (which induces a success probability p > q), the accounting system errors  and
, earnings management, and audit effort. They are stated in the proofs.
Lemma 1: Optimal earnings management is bH = 0 and

s  CM 
bL  (1  gˆ H ) 1  f   0. (3)
v  s 
The lemma confirms that the manager overstates earnings if the initial signal is low, yL, but never
understates high earnings yH. Note that, because gˆ H < 1, even a perfect enforcement (f  1) cannot
fully deter upwards earnings management as long as CM < s.5
The probability of an enforcement action determines the expected cost of enforcement for each of
the parties involved. Observe that there is no risk of an enforcement action if the manager does not
manage earnings. Since the manager has only an incentive to overstate earnings, she manages
earnings bL if the accounting system reports yL. The auditor detects earnings management with
probability gH and corrects it. With probability (1 – gH), earnings management prevails and is
detected by the enforcer with probability f. Taken together, the ex ante probability that the enforcer
initiates an enforcement action and imposes enforcement costs is
prob(error) = prob(yL)bL(1 – gH)f . (4)
The auditor’s strategy is determined as follows. After accepting the audit engagement, the auditor
chooses gi to maximize his expected utility, conditional on the preliminary report mi, i = L, H,
k
U A  mi   A  gi2  prob(error mi ) C A . (5)
2
The expected utility comprises the endogenously determined audit fee A, the cost of audit effort,
and the expected penalty of an enforcement action. Exerting higher effort reduces the probability of
an enforcement action but incurs higher disutility.
Lemma 2: The optimal audit effort levels for mL and mH are: gL = 0 and
prob(yL )bˆL CA
gH  f . (6)
prob(yL )bˆL +prob(yH ) k
 prob(yL mH )
A perfect Bayesian equilibrium in this manager-auditor game requires that the following conditions
hold, where i, j = L, H:
(i) {bi*} maximizes the manager’s conditional expected utility given conjectures {gˆ j };
5
For example, a clawback provision (e.g., Section 304 of the Sarbanes-Oxley Act and rule 954 of the Dodd-
M
Frank Act) of bonuses based on erroneous financial reports implies C = s, so full deterrence, bL = 0, would
occur for f = 1.

(ii) {g *j } maximizes the auditor’s conditional expected utility given conjectures {bˆi };
the conjectures are fulfilled, i.e., bˆi  bi and gˆ j  g j .

* *
(iii)
The next proposition establishes a unique equilibrium.
Proposition 1: For any s that induces aH, there exists a unique equilibrium with earnings management
s  CM  CA
bL* = (1  g H* ) 1  f  > 0 and bH
*
= 0 and audit effort g *
L = 0 and g *
H = prob( y L mH ) f
v  s  k
> 0.
The equilibrium strategies equal those stated in Lemma 1 and 2 (equations (3) and (6)), after
replacing conjectures by the respective other party’s equilibrium strategies. We show in the proof
that this equilibrium is unique. The equilibrium strategies are stated implicitly because they depend
on each other in nontrivial ways.
4. Effects of strengthening enforcement on equilibrium strategies

In this section, we examine how strengthening enforcement affects equilibrium earnings
management bL* and audit effort g H* . We continue to assume an s that induces aH and consider
optimal contracting in Section 0.
Enforcement strength increases in the enforcement intensity f with which the enforcer detects
errors and in the enforcement penalties CO, CM, and CA that it imposes on the owner, manager, and
auditor. A regulator can increase enforcement intensity by increasing the (benevolent) enforcer’s
budget. Penalties are typically bounded from above by considerations that they must be
proportional to the crimes. We show how a variation of each of these parameters individually affects
the equilibrium outcomes. Because we do not include costs of enforcement (by increasing f) and
other considerations (such as the appropriateness of penalties in a legal system), we do not study
the optimal design of an enforcement regime.
4.1. Enforcement intensity

Our first key result is the effect of strengthening enforcement on the equilibrium strategies.
Proposition 2: Increasing enforcement intensity f has the following effects:

(i) bL* strictly decreases;
(ii) g H* strictly increases if f < f0 and strictly decreases if f > f0, where
1 s k 
f 0   M  g H* ( f 0 ) A  . (7)
2C C 

Proposition 2 (i) confirms the intuitive result that earnings management strictly decreases in f. Yet
this result is less obvious than it appears. Earnings management and audit effort interact in
equilibrium, so the effect of f on bL* depends on the endogenous behavior of g H* , which is
nonmonotonic.
Proposition 2 (ii) states that equilibrium audit effort g H* strictly increases for low f but can strictly
decrease for high f, depending on whether its maximum is attained within the feasible range of f.
Thus, the proposition establishes a complementary relation between audit effectiveness and
enforcement intensity if it is low and a substitutive relation, or crowding out, if it is high. To see this
result, note that higher f directly increases g H* because it raises the likelihood that the enforcer finds
earnings management. This again increases the expected penalty on the auditor. Then there is an
indirect effect: a higher f mitigates earnings management bL* , which reduces the likelihood that the
audit detects errors. This effect leads to a decrease in audit effort through a decrease in the
probability prob(yLmH) that the low accounting signal prevails, given that the manager’s report is
high. This probability is increasing and strictly concave in earnings management, which implies that
the effect of a lower bL* on prob(yLmH) is stronger the lower bL* becomes. As is apparent from the
expression (6) for the optimal audit effort, the marginal direct increase of g H* for higher f declines in
f, while the indirect negative effect grows. Thus, when earnings management is large, then
increasing f, starting from a low level, increases audit effort strongly and only slightly reduces the
probability prob(yLmH), which determines the auditor’s expected penalty; hence, the direct effect
dominates. When f is already high, then a further increase has a stronger effect on prob(yLmH),
inducing the auditor to exert less audit effort.
*
The enforcement intensity for which g H attains its unique maximum is
1 s k 
f 0   M  g H* ( f 0 ) A  .
2C C 
*
Equilibrium audit effort g H decreases in f for f > f0. Given our constraint that CM ≤ s, the value of f0
> 1/2. However, f0 can be greater than 1, so that there is no feasible interval of f in which audit effort
decreases in f. Note that enforcement intensity and enforcement penalties determine the strength
of enforcement. CM and CA drive the threshold f0 directly downward, although equilibrium audit
effort also depends on these penalties.

Figure 3: Enforcement intensity and equilibrium earnings management and audit effort
* *
Figure 3 plots the equilibrium earnings management bL and audit effort g H for the full range of
enforcement intensity f ∈ [0, 1]. The underlying parameter values are p = 0.3,  = 0.05,  = 0.05, s =
*
0.6, v = 10, CM = 0.5, and CA/k =1. Equilibrium earnings management bL always decreases in
*
enforcement f, whereas equilibrium audit effort g H increases in f up to f0 ≈ 0.62 and then
decreases.
4.2. Enforcement penalties

Enforcement strength increases in the magnitude of penalties of enforcement actions imposed on
the owner (CO), manager (CM), and auditor (CA), respectively.
Proposition 3: Increasing enforcement penalties has the following effects:

(i) bL* and g H* are unaffected by CO;
(ii) bL* and g H* strictly decrease in CM;
(iii) bL* strictly decreases in CA and g H* strictly increases in CA.
The owner’s penalty CO has no immediate effect on the reporting equilibrium because it affects
neither the manager’s nor the auditor’s expected utility directly. Its only effect is that it raises the
owner’s cost of motivating high productive effort aH, which ultimately can become so high that the
owner foregoes implementing aH and prefers the low effort aL, which can be induced by a fixed wage
contract that avoids earnings management altogether.

Proposition 3 (ii) states that the higher the manager’s penalty CM, the lower is equilibrium earnings
management. This effect is a direct consequence of the increasing strength of public enforcement.
However, the lower earnings management induces the auditor to reduce the audit effort in
equilibrium, which indirectly increases the manager’s incentives for earnings management again.
The proposition shows that the direct mitigating effect of a higher penalty on bL* prevails, thus
inducing a strict decrease of earnings management in equilibrium. That is, the intuition does not
hold that, to deter earnings management, one should reduce the manager’s penalty CM so as to
induce more earnings management and, with that, induce the auditor to work harder.
Proposition 3 (iii) states the effect of an increase of the auditor’s penalty CA. A higher penalty CA (or a
*
lower k) directly increases the incentive for the auditor to exert higher audit effort g H . The
increasing audit effort unambiguously reduces equilibrium earnings management. The relevant
parameter for the equilibrium strategies is the ratio CA/k, which reflects the relative importance of
the enforcement penalty relative to the level of the audit effort cost.
5. Effects on accounting outcomes

5.1. Financial reporting quality
An objective of enforcement is to improve the quality of mandatory financial reporting. Financial
reporting quality captures the notion of the usefulness of financial reports for investors’ decisions.
The empirical literature has developed several proxies for earnings quality, which attempt to capture
aspects of information usefulness. In our model, we distinguish two measures based on what is the
underlying benchmark: the (future) outcome x or the preliminary accounting report y. The first
measure captures all errors, intentional or unintentional, whereas the second captures only
intentional errors. Intentional errors arise through earnings management, whereas unintentional
ones include the base accounting errors  and .6 For example, the earnings quality measure of
Dechow and Dichev [2002] includes both kinds of errors, whereas the modified Jones model
(Dechow, Sloan, and Sweeney [1995]) includes intentional errors only.
Our first measure defines financial reporting quality as the ex ante probability that the report
accurately informs about the productive outcome x; that is, rH = xH and rL = xL. Given the manager
takes the desired effort aH, this is
FRQ  1  prob(rL )prob(xH rL )  prob(rH )prob(xL rH )

(8)
 1  prob(xH , rL )  prob( xL , rH ).
6
Francis, Olsson, and Schipper [2006] similarly distinguish between innate and discretionary sources for
earnings quality.

Here, prob(xH , rL ) is the probability that the report understates the outcome, and prob(xL , rH ) is
the probability that it overstates it. This FRQ definition assumes equal weights of understatement
and overstatement errors.7 The following result states the effect of an increase of the strength of
enforcement on FRQ.
Proposition 4: Financial reporting quality FRQ strictly increases in enforcement intensity f, in the
auditor’s penalty CA, and in the manager’s penalty CM if Q > 0; it strictly decreases in f, CA, and CM if Q
< 0, where
Q ≡ (1  p)(1   )  p . (9)
The proposition shows that FRQ either monotonically increases or decreases in f, in CA and CM,
depending on the sign of the term Q. To see this, we rewrite FRQ by inserting the probabilities,
which yields
FRQ  1   p  (1  p)    bL (1  g H )  (1  p)(1   )  p  . (10)

Base accounting quality Change due to enforcement
FRQ depends on the base accounting quality that is determined by the - and -error and a term
that is affected by a change in equilibrium earnings management and audit effort, both of which are
 
influenced by enforcement strength. We show in the proof that the term bL (1  g H ) strictly
*
decreases in bL and thus strictly decreases in f, in CA, and in CM.8 The effect on FRQ is therefore
determined by the sign of Q.
Note that the ex ante probability of a report yL is
prob( yL )  (1  p)(1   )  p ,
which consists of two parts: (1 – p)(1 – ) is the probability that x = xL and y = yL, which is a correct
depiction of the economic outcome, while p is the probability that x = xH but the accounting system
falsely reports y = yL. If the manager manages earnings upon observing yL, she reports mH with
*
probability bL > 0. If x = xL, then earnings management disguises the originally correct signal yL,
which adds to an overstatement of the financial report. We call this bad earnings management.
Conversely, if x = xH, then the accounting signal y = yL is incorrect, and upwards earnings
management corrects the understatement error. We call this good earnings management. If Q < 0,
that is,
7
The cost of an under- or overstatement can vary with the individual decision problem in which the financial
report is used. Applying different weights does not qualitatively affect our results.
8 O
A variation of the owner’s penalty C has no direct effect (see Proposition 3 (i)).

(1  p)(1   )  p ,
then the probability that earnings management corrects an understatement error is greater than the
probability that it aggravates an overstatement error. According to Propositions 2 and 3,
strengthening enforcement through either increasing f, CA or CM strictly mitigates bL . Therefore, if
earnings management is bad, then less of it improves financial reporting quality; if it is good, then
less of it reduces financial reporting quality because it diminishes the error-correcting function of
earnings management.
Two notes are in order. First, stronger enforcement still fulfils a primary function, which is
deterrence of earnings management. And second, even if earnings management is good, it is not the
manager’s intent to do something good, but managing earnings still follows from the incentive to
increase compensation.
Figure 4 plots the financial reporting quality FRQ on enforcement intensity f ∈ [0, 1] and three
different productive probabilities p. The underlying parameter values are  = 0.2,  = 0.2, s = 0.6, v =
10, CM = 0.5, and CA/k =1. p = 0.8 is the knife-edge case in which Q = 0, which implies that FRQ is
unaffected by a change in enforcement strength. A lower p yields a Q > 0, so that earnings
management is bad, in which case increasing enforcement intensity monotonically increases FRQ.
p = 0.7 illustrates this. If p > 0.8, in the Figure p = 0.85, Q < 0 and earnings management is good, so
that FRQ decreases in f.
Figure 4: Enforcement intensity and financial reporting quality

The following corollaries state conditions under which Q is more likely to be negative, with the
consequence that FRQ decreases.
Corollary 1: FRQ is likely to decrease in f, CA, and CM (i.e., Q decreases),

(i) the greater p is;
(ii) the greater the errors  and  are.
The results follow immediately from the inspection of Q = (1  p)(1   )  p . First, firms that are
more likely to generate high output (high p) make erroneous understatements of accounting signals
more frequently, which are corrected by upward earnings management. Second, the less precise the
base accounting system is—that is, the larger the accounting errors  and  are—the lower is Q,
because there arise more instances that benefit from a correction.
While less precision tends to generate a negative effect of stronger enforcement on FRQ, accounting
bias has distinct effects depending on the situation. We parameterize conservative accounting by a
parameter ; higher  implies higher conservatism. Let      ,      , and denote with
Q the original term Q with   and  .
Corollary 2: (i) If p  ½, greater conservatism strictly decreases FRQ if Q ≤ 0; otherwise the effect is
ambiguous.
(ii) If p < ½, greater conservatism strictly increases FRQ if Q  0; otherwise the effect is ambiguous.
 
To establish this result, we show in the proof that undetected earnings management bL (1  g H )
strictly decreases in conservatism . To see this, note that a greater  increases prob(yL) and
decreases prob(yH) by the same amount, thus increasing prob(yL mH ) and consequently the audit
effort. Intuitively, under higher conservatism, the low accounting signal realizes more frequently and
raises the likelihood that a high preliminary report mH is the result of earnings management. The
auditor responds by increasing the audit effort. There is a countervailing effect because higher audit
effort reduces the manager’s optimal bias, but it is not sufficient to outweigh the positive impact of
.
The probability of understatement and overstatement errors depends on the probability p of the
high outcome xH. If p  ½, more conservatism increases the sum of the accounting errors because

the increase in the understatement error is larger than the decrease in the overstatement error.9 As
before, the impact of earnings management depends on the relation between understatement and
overstatement errors. More conservatism reduces undetected earnings management, and FRQ
strictly decreases with greater  if p  ½ and Q < 0 because then earnings management is good. The
other statements of the corollary follow from a similar reasoning. Taken together, the effect of
conservatism on financial reporting quality depends on the parameters and can be ambiguous.10
Our second measure of financial reporting quality uses the preliminary accounting report y as
benchmark, which is unaffected by earnings management, and it focuses on the effects of auditing
and enforcement on earnings management. Define
FRQ EM  1  prob(rL )prob(yH rL )  prob(rH )prob(yL rH )

(11)
 1  prob(yH , rL )  prob( yL , rH ),
where prob(yH , rL )  0 and prob(yL , rH )  (1  p)bL (1  g H ) .

* *
Proposition 5: Financial reporting quality FRQEM strictly increases in f, CA, and CM.
This result follows directly from the fact that bL (1  g H ) strictly decreases in enforcement intensity f
* *
and the penalties CA and CM, which we have shown in Proposition 4. Since this definition does not
consider the - and -errors that arise in the accounting system, earnings management cannot
correct such errors, and earnings management is always undesirable. Reducing earnings
management thus unambiguously improves financial reporting quality FRQEM.
Comparing the results for both measures of financial reporting quality reveals different effects of
strengthening enforcement. While the effect on FRQEM, which captures earnings management only,
is consistent with conventional intuition, the effect on the more comprehensive FRQ depends on
circumstances, which are the production technology and the accounting system errors. Thus it is
9
This resembles the result in Gigler, Kanodia, Sapra, and Venugopalan [2009] on conservatism in a debt
contracting setting with no earnings management. They show that debt contract efficiency (which is their
measure of accounting quality) declines with more conservatism because the increase in understatement error
dominates the decrease in overstatement error. This result hinges on the assumption of a relatively high
expected outcome, which is akin to p  ½ in Corollary 2 (i).
10
Chen, Hemmer, and Zhang [2007] study an agency model with earnings management, but they do not
consider auditing and enforcement. They show that a small amount of conservatism enhances earnings
informativeness and contracting efficiency. While their model’s specifics differ from ours, the impetus is that
conservative accounting mitigates earnings management, which is similar to Corollary 2.

important, in an empirical study, to fit the measure of financial reporting quality to the predictions
and testable hypotheses.
5.2. Likelihood of enforcement actions

A measure of enforcement intensity in empirical studies is the number of enforcement actions
among firms subject to enforcement. In our model, this proportion equals the likelihood that the
enforcer finds an error, which is the ex ante probability (see equation (4))
prob(error)  prob( yL )bL* (1  g H* ) f .
An enforcement action occurs if the signal yL realizes, the manager succeeds in overstating earnings
and reports mH, and the auditor does not find the overstatement but the enforcer discovers y = yL.
Proposition 6: (i) An increase of the enforcement intensity f strictly increases the likelihood of an
enforcement action if f < f1 and strictly decreases it if f > f1, where f1  s 2C  f 0 .
M
(ii) An increase in the penalties C M or C A strictly decreases the likelihood of an enforcement action.
The proposition suggests that using the likelihood of an enforcement action is a reliable measure for
enforcement strength only under specific circumstances. As we show above, bL (1  g H ) declines in
* *
f; hence increasing the enforcement intensity f causes countervailing effects on prob(error). If the
enforcement level is low, increasing f strictly increases the likelihood of an enforcement action.
However, if enforcement intensity increases, it mitigates earnings management and the likelihood of
an enforcement action decreases. We show in the proof that, due to these countervailing effects,
there exists a level f1 < f0 for which the likelihood of an enforcement action reaches a maximum. In
case f1 exceeds 1, the maximum is outside of the relevant range for f  [0,1] and prob(error) strictly
increases for all feasible f.
The proposition further states that an increase in either of the penalties CM and CA strictly decreases
the likelihood of an enforcement action. With greater penalty CM, the manager reduces earnings
management, which implies that the basic need for a correction of the published financial
statements declines. The auditor responds by reducing his audit effort, but as the proof shows, this
effect is eventually not large enough to outweigh the impact of reduced earnings management. A
greater penalty CA induces the auditor to extend his audit effort, thus finding mistakes more
frequently. The manager responds by reducing earnings management. Here, both responses work in
the same direction, and both reduce the likelihood of an enforcement action.
Considering the relation between the likelihood of an enforcement action and financial reporting
quality, we note an enforcement action itself is not free of error. An enforcement action arises in
two distinct events. First, the actual outcome is xL, which is correctly reported by the accounting
system as signal yL. The manager succeeds at overstating earnings as mH. The auditor does not
observe y. Hence the report is rH, but the enforcer finds out yL and initiates an enforcement action.
The probability of this event is

(1  p)(1   )bL* (1  g H* ) f .
Second, the actual outcome is xH, which is incorrectly reported by the signal yL. The manager
succeeds at overstating earnings as mH. The auditor again does not observe y, but the enforcer finds
out yL and initiates an enforcement action. However, given x = xH, the enforcement action wrongly
corrects the (ex post) appropriate financial report. The probability of this event is
p bL* (1  g H* ) f .
Comparing the two probabilities, it is apparent that the error through enforcement is greater than
the corrective function if Q < 0, that is, when earnings management is good.
5.3. Audit quality and audit fees

We next examine the effect of a variation of enforcement strength on audit quality. Our measure for
audit quality is the audit effort the auditor expects to exert in equilibrium, because this effort
increases the probability that the auditor discovers earnings management. Other factors of the audit
technology or competency of the auditor are held constant in our model. Audit quality is defined as
AQ  prob(mL )g L*  prob(mH )g H*
0 (12)
  prob(yL )b  prob(yH )  g .

L
*
H
Proposition 7: (i) An increase of the enforcement intensity strictly increases audit quality AQ if f < f2
and strictly decreases it if f > f2, where f 2  f 0 .
(ii) Audit quality AQ strictly decreases in the penalty CM.
(iii) Audit quality AQ strictly increases in the penalty CA for small CA. It always strictly increases in CA if
prob(yH )
 bL  2 f  1  0 , (13)
prob(yL )
where f  min{1; f 0 ( Ck  1)}.

A
 
Audit quality AQ is a function of a weighted product of g H and bL , but it can be restated as a

function of bL alone, resulting in
CA 
AQ  prob(yL )b f .
L
k
 A 
The crucial term is bL fC , whose impact is ambiguous because bL strictly decreases in f and CA.
Proposition 7 (i) states that AQ is an inverse u-shaped function of enforcement intensity f. Intuitively,
this result follows from Proposition 2 that audit effort is inversely u-shaped. The difference is that
the maximum AQ is achieved at a lower f than the maximum of that of audit effort, that is, f2 < f0.

Therefore, the range of f for which AQ declines in enforcement intensity is greater than that of audit
effort. However, it is possible that f2 > 1 so that AQ always increases in f.
The only monotonic relation is stated in part (ii) of the proposition: AQ strictly decreases in the
manager’s penalty CM. An increase in CM mitigates earnings management, which induces a decrease
of the audit effort and lowers the probability of a high preliminary accounting report mH. Thus ex
ante, the audit effort strictly decreases in CM.
The impact of an increase in CA on audit quality is subtle. Since AQ = 0 if f = 0 or CA = 0 but is strictly

positive for positive f and CA, it strictly increases if CA is originally small. Otherwise, a further increase
of f can decrease audit quality. The behavior of AQ for a variation of CA depends on the ratio of the
probabilities of obtaining the high and low accounting signal, prob(yH ) prob(yL ) . If this ratio
exceeds a threshold, then audit quality always strictly increases in CA. This threshold is defined in
bL  2 f  1  bL  1 ,
implying that the condition (13) holds for a wide set of parameter values. For instance, if prob(yH) 
prob(yL), then the condition is always fulfilled. Also, the less conservative the accounting system is,
the higher is prob(yH) and the lower is prob(yL), thus increasing the probability ratio. Intuitively,
audit quality is
AQ  prob(mH )g H* .
Hence a less conservative accounting system increases the probability prob(mH) that the high
preliminary accounting signal obtains and the auditor exerts audit effort. This attaches a higher
weight to the positive impact of a greater CA on audit effort and a lower weight on the reduction of
the bias. When the probability ratio is large enough, the positive impact of CA on audit effort always
outweighs the negative impact on earnings management, and audit quality always strictly increases
in CA.
Empirical studies often use audit fees as a measure for (unobservable) audit quality. In our model,
the owner hires the auditor at the beginning of the game, and the audit fee is endogenously
determined in a competitive audit market with homogenous auditors. It is based on the anticipated
audit effort and the expected cost of an enforcement action. In equilibrium, the auditor’s conditional
utility given mH equals
k
U A  mH   A  ( g H* ) 2  prob( yL mH )(1  g H* ) fC A
2
k
 A  g H* (2  g H* ).
2
If m = mL, the auditor exerts no effort, but because the manager has not managed earnings there is
no cost from enforcement in this case.

The auditor accepts the audit engagement if the expected utility is greater or equal to zero.
Therefore, the required audit fee equals the expected cost of auditing,
k
A  prob  mH  g H*  2  g H* 
2 (14)
k
  prob  yH   prob  yL  b  g H*  2  g H*  .

L
2
Proposition 8: (i) An increase of the enforcement intensity strictly increases the audit fee A if f < f3
and strictly decreases it if f > f3, where f3  f 2 .
(ii) The audit fee A strictly decreases in the penalty CM.
(iii) The audit fee A strictly increases in the penalty CA for small CA. It always strictly increases in CA if
prob(yH )
 bL  3 f  1  0
prob(yL )
where f  min{1; f 0 ( Ck  1)}.

A

The functional form of the audit fee is determined by the induced changes on the equilibrium bL
  *
and g H . Earnings management bL decreases in f, whereas the effect of f on g H depends on the
level of enforcement before f increases further. Proposition 2 (ii) establishes an inverse u-shaped

effect and a threshold value f0 that g H decreases in f if f > f0. A decrease, dg H df  0 , is a
*
sufficient condition that the equilibrium audit fee declines. Then increasing f not only reduces
earnings management but also the cost of the audit. Conversely, if dg H df  0 , then the cost of
*
audit effort rises and, with it, the necessary fee, whereas the lower earnings management reduces
audit effort again. We show in the proof that these effects result in the existence of a level f3 at
which the audit fee reaches a maximum and that this level is smaller than the enforcement intensity
that maximizes audit quality AQ (which is, in turn, smaller than the level that maximizes audit effort).
Thus, stronger enforcement increases audit fees only if public enforcement is sufficiently weak.
A higher managerial penalty CM strictly decreases the audit fee. This follows because a greater CM
reduces earnings management, which again reduces the probability of obtaining the high
preliminary report mH and audit effort.
An increase of the auditor’s penalty CA has a similar effect on the audit fee as it has on audit quality
(Proposition 7 (iii)), and the same intuition applies. The proposition states a sufficient condition that
A always strictly increases in CA. The only difference is that the required lower bound for P is slightly
greater than the corresponding threshold for audit quality AQ.

Figure 5: Enforcement intensity, audit quality, and audit fee
Figure 5 depicts how enforcement intensity affects equilibrium audit quality AQ and audit fee A. The
underlying parameter values are p = 0.3,  = 0.05,  = 0.05, s = 0.6, v = 10, CM = 0.5, and CA/k =1.
Audit quality and audit fee are inversely u-shaped in f because its primary determinant is the audit
*
effort g H . The audit fee also explicitly captures expected penalties from enforcement.
6. Optimal bonus contract

As we discuss in Section 0, the optimal compensation contract with the manager is a simple bonus
contract that pays s > 0 if r = rH and 0 if r = rL. The size of the bonus s is crucial to induce the manager
to exert productive effort aH, but it also provides incentives for the manager to manage earnings.
Highly sensitive management compensation, based on accounting numbers, has often been accused
of providing strong incentives for managers to manage earnings, and there have been several
corporate governance initiatives aimed at constraining management bonuses. Yet such constraints
would also discourage the manager’s productive effort.
We begin with recording the effects of the bonus s on earnings management and on audit effort in
equilibrium.
Corollary 3: Increasing the bonus s has the following effects:

*
(i) bL strictly increases;
*
(ii) g H strictly increases.

A greater s increases the incremental benefit of earnings management, which provides stronger
incentives to manage earnings. And the higher earnings management induces higher audit effort in
equilibrium. While the higher audit effort mitigates earnings management, which works against the
direct increase through higher s, the corollary establishes that the net effect is an increase in
earnings management, so the direct effect prevails.
In our analysis so far, we have assumed the bonus s is predetermined, which reflects the fact that, at
the beginning of the game, the owner hires the manager and writes the compensation contract.
Later, there is a change in the strength of enforcement, but the contract is unchanged. We now
derive the optimal contract, under the assumption that the owner can write a new contract or adjust
an existing contract, with the manager after a change in enforcement strength. We assume that the
owner is a Stackelberg leader in the game, that is, she writes the compensation contract ex ante, and
it is observable to the auditor.
The owner chooses s to maximize the expected utility,
E[U O aH ]  (1  p) xL  pxH  prob(rH )s  A  prob(error)C O . (15)

Audit fee
Expected outcome Expected compensation Expected cost
of enforcement
It consists of the expected outcome, the manager’s expected compensation, the (equilibrium) audit
fee, and the expected cost of enforcement in case the enforcer detects an error in the financial
report and penalizes the owner at CO.
The manager’s reservation utility is always satisfied because of the limited liability constraint, that is,
s ≥ 0, and the reservation utility is normalized to 0. Because we assume the owner wants to
implement aH, the bonus must be sufficiently high to induce the manager to choose the productive
effort aH over aL. The manager’s incentive compatibility constraint is
E[U M aH ]  E[U M aL ] .
The expected utility when choosing aH is
v
E[U M aH ]  prob(rH )s  V  prob( yL ) bL*2  prob( yL )bL* (1  g H* ) fC M .
2
E[U M aL ] is the expected utility if the manager chooses the out-of-equilibrium effort aL and also
the out-of-equilibrium earnings management bLL  bL ( g H aL ), 11 whereas the auditor still
* *
* *
conjectures (aH , bL ) and does not adjust the equilibrium audit strategy g H :
11 *
We prove in Proposition 9 that equilibrium earnings management is independent of a, i.e., bLL  bL* .

v *2
E[U M aL ]  prob(rH aL )s  prob( yL aL ) bLL  prob( yL aL )bLL
*
(1  g H* ) fC M .
2
The following result obtains.
Proposition 9: The optimal bonus is
V v
s   bL2 . (16)
 p  q 1      2
Strengthening enforcement by increasing f, CM, or CA strictly decreases s*.
The optimal bonus compensates the manager for productive effort and earnings management. The
compensation for productive effort is just high enough to motivate the manager to induce her to
exert effort aH, and it is higher than the disutility V depending on (p – q), which is the difference in
productivity from the two actions and the precision of the accounting system (1 –  – ). The bonus
includes full compensation for the induced earnings management.
Proposition 9 also shows that strengthening enforcement through either instrument, enforcement
intensity f or the penalties CM and CA, lowers the optimal bonus s*. Intuitively, the manager’s
expected utility depends on the information content of the financial report rH, which is affected by
* * *
the equilibrium strategies bL and g H . An increase in f or a penalty CM or CA decreases bL ; thus, the
owner can reduce the amount of the bonus and still motivate the manager to choose aH. The
owner’s penalty in case of an enforcement action, CO, does not affect the bonus. A higher CO
increases the owner’s expected cost of inducing high productive effort; hence, if CO grows too large,
the owner is better off paying flat compensation and inducing the manager to exert low effort aL,
which eliminates earnings management and avoids an enforcement action.
A lower optimal bonus also mitigates earnings management (Corollary 3), which has an indirect
effect on the equilibrium, because audit effort may go down. The next proposition assures that our
main results continue to hold when s* is endogenous.

Proposition 10: With an endogenous bonus s*, equilibrium earnings management bL and audit effort
g H behave as follows:

(i) bL strictly decreases in f, CM and CA.

(ii) An increase of the enforcement intensity f strictly increases the audit effort g H if f < f4
and strictly decreases it if f > f4.

(iii) g H strictly decreases in CM.

(iv) g H strictly increases in CA.

Proposition 10 (i) reflects the fact that the reduction of the bonus reinforces the direction of the
change in earnings management caused by the direct effect of an increase in the respective
parameter. Part (ii) confirms that the inverse u-shaped function of equilibrium audit effort in f holds
when s* is endogenous. The fact that s* strictly decreases in f reinforces a negative effect of
enforcement intensity on audit effort.12 Similarly, part (iii) of the proposition follows from the fact
that the optimal bonus strictly decreases in the penalty CM, thus reinforcing the negative direct
impact of CM on audit effort. Finally, part (iv) states that audit effort strictly increases in CA, which is
less obvious, as there are two countervailing effects of the penalty CA. Audit effort increases in CA
directly but decreases, due to the lower bonus. As we establish in the proof, the positive effect of
higher CA outweighs the negative effect.
As we show in Section 5, financial reporting quality and audit quality ultimately depend on the

behavior of bL for strengthening enforcement, Proposition 10 implies that our earlier results also
carry over to an endogenous contracting setting.
There may be contracts other than our simple bonus contract. For example, the contract can be
augmented with a clawback provision. That is, if the enforcer finds and publishes an error, the owner
can require the manager to repay a bonus. The manager’s expected compensation becomes
prob(rH )s  prob(error) s ,
and the expected clawback prob(error)s increases the expected utility of the owner. The
introduction of a clawback provision does not alter our main results.
A more complex contract is a truth-telling contract, in which the owner requests a report yR from the
manager about y and makes compensation contingent on yR and r. Under the conditions underlying
the revelation principle, a payoff-equivalent truth-inducing contract can then be implemented,
which prevents earnings management. The auditor chooses the audit effort sequentially rationally
12
This suggests f4 < f0, i.e., with endogenous bonus, crowding out of auditing occurs already for lower f than
with fixed bonus, but the relation is subtler because in the setting of Proposition 2 (where we establish f0), the
bonus is set arbitrarily subject only to s  CM and the manager’s incentive compatibility constraint. However,
we show in the proof of Proposition 10 that for each f and a corresponding bonus s*(f) for which crowding
would occur holding s*(f) constant, there is also crowding out with an endogenous bonus.

and exerts no effort. Enforcement is still effective because it is nonstrategic, but it will never find an
error, because the manager does not manage earnings; as a consequence, there is no enforcement
cost on the auditor. There is still a role for enforcement, because it improves contracting by making
it cheaper to induce truth-telling. The manager’s out-of-equilibrium strategy of managing earnings
becomes costlier with increased enforcement. But auditing is of no value and does not occur in such
a setting. Since we do observe earnings management and auditing in practice, the conditions for a
truth-telling contract are likely limited.
7. Extensions
7.1. Auditor generates additional information
We assume that auditing and public enforcement have basically the same audit or investigation
technologies available. That is, the auditor uncovers the raw earnings (signal y) with probability g,
which is determined by costly audit effort, and the enforcer uncovers the signal yj with probability f.
The probabilities g and f are uncorrelated. If g was nonstrategic, we would always have increasing
earnings-management deterrence by increasing either g or f. With a strategic choice of g by the
auditor, we show that earnings management still decreases but g and f are strategic complements
for low f and strategic substitutes for high f.
In reality, the scope and depth of an audit is greater than that of an enforcement investigation.13 An
audit comprises tests of controls and substantive procedures, including analytical procedures and
tests of details, for example, providing audit evidence of physical inventory, bank balances, loan
quality, and the like, to identify material misstatements. Enforcement does usually not perform tests
of internal controls or completeness of the bookkeeping system and inventory but instead focuses
on critical accounting positions, many of which are subject to high judgment. Thus, the scope of
enforcement is much more limited; in other words, the enforcer does not perform another audit.
Recall that our reporting system contains two kinds of errors: one is an intentional error introduced
by earnings management, but another comes from the imprecision of the accounting system to
capture the productive outcome x perfectly, symbolized by the -error and the -error. A key
determinant of - and -errors is the effectiveness of the firm’s internal controls. The effectiveness
of internal controls is subject to an assessment by the auditor, who has to report on control
weaknesses.
13
For the variety of audit activities, see Dye [1993, 1995], Schwartz [1997], Chan and Pae [1998], Pae and Yoo
[2001], Chan and Wong [2002], Laux and Newman [2010], and Ye and Simunic [2013, 2017].

In the following, we capture these differences by assuming that the auditor learns both the raw
accounting signal y and additional information about the true outcome x, for example, by probing
into the internal controls, thus effectively learning about - or -errors. For parsimony, we simply
assume that the auditor observes {x, y} with probability g. In practice, there are limits to learning x,
but all that we want to achieve is to model that auditing has more scope than enforcement.
To add structure, assume that, since x is always more informative than y, the auditor corrects the
financial report to include x rather than y whenever they are observed. The audited financial report
is as follows:
 xi with probability gi
ri  
mi with probability (1  gi ).
If the enforcer obtains yi, the investigation ends without a finding if the report ri equals yi (i = L, H);
otherwise the enforcer alleges an error. However, if the auditor discovered x during his audit, he can
present evidence that ri = xi, and the enforcer accepts this evidence and ends the investigation. If the
enforcer finds out yi ≠ rj and there is no evidence about x available, the enforcer states an error and
imposes penalties to the parties.
The inclusion of superior auditing does not alter the main results of the analysis. In particular,
*
Proposition 2 still holds, which states that increasing enforcement intensity f, bL strictly decreases
* *
and the behavior of g H is inversely u-shaped. That is, enforcement f and g H are complements for
low f and substitutes for high f.
The main difference lies in the effect of increasing enforcement intensity on financial reporting
quality FRQ. The next result describes the effects, where we hold the bonus s constant to be able to
compare it with Proposition 4.
Corollary 4: If auditing provides more information than enforcement investigations,

(i) FRQ can be nonmonotonic in enforcement intensity;
(ii) FRQ can decrease even if earnings management is bad as long as f is sufficiently high.
The corollary follows immediately from Proposition 4 and the fact that the information auditing can
*
provide depends on the level of audit effort g H . The probability of an error in the financial reports,
after auditing and enforcement, is the same as stated in (10), but the auditor’s corrective function by
substituting x for r is now valuable and improves FRQ in its own right. As long as a higher
*
enforcement intensity increases g H as well, it reinforces the improvement of FRQ that we describe

in Section 0. However, if enforcement crowds out auditing (i.e., g H* declines in f), the superior
corrective function of auditing is also reduced. In this case, FRQ can decrease, even if earnings
*
management is bad (Q > 0). The corrective effect is highest at the maximum g H at f = f0, and a
further increase in f reduces financial reporting quality by crowding out the auditor’s effort, which
must then be weighed against the direct benefit of the higher f in case of bad earnings management.
7.2. Audit oversight

In our main analysis, we assume that the incentives for the auditor to exert effort stem from the
expected penalty CA if the enforcer finds an error later. Recall the expected utility of the auditor
from (5) is
k
U A  mi   A  gi2  prob(error mi ) C A ,
2
where the audit fee A is fixed already and avoiding CA is traded off against higher audit effort g. Since
audit fees are noncontingent in most jurisdictions, auditors face several other disciplining
mechanisms that substitute for the lack of continent fees, specifically audit oversight and legal
liability.
Audit oversight institutions, for example, the U.S. Public Company Accounting Oversight Board
(PCAOB), monitor auditors and can penalize them if they do not follow the auditing standards, even
if financial reports turn out to be correct later. We can include audit oversight parsimoniously by
assuming that it ensures that the auditor exerts a minimum audit effort level 0 < g < 1, regardless of
the audit risk of the client and strategic incentives.
Our main results are structurally unaffected by the introduction of g as long as the equilibrium audit
* *
effort g H > g . Otherwise the audit effort g H = g and is not chosen strategically any more. Hence
auditing with g makes it a technology just like our enforcement.
Legal liability arises through litigation by investors who relied on the audited report. Litigation is
typically triggered if an enforcement action was initiated or if it becomes apparent that the audited
report was wrong. If investors sue the manager and the auditor after an enforcement action, the
effect of legal liability is mainly an increase in CM and CA. If it is based on later indicators, litigation is
asymmetric in that investors sue only if the firm reported rH and the actual outcome turned out to
be xL (ignoring issues of hindsight).14 Litigation is another strategic decision that can affect our
results. The interrelation between enforcement and litigation is an interesting topic for further
research.
14
See Chan and Pae [1998] and Ewert [1999].

8. Empirical implications and conclusions
This paper challenges the conventional view that increasing enforcement of financial reporting
always increases financial reporting quality and audit quality. This view neglects the fact that the
strategies of managers and auditors are jointly determined in equilibrium and depend on each other.
Our main result is that increasing enforcement intensity increases audit effort if the enforcement
regime is relatively weak and decreases audit effort if the opposite is true. The reason for this
crowding out is that audit effort is driven not only by enforcement but also by the anticipated
earnings management, which is mitigated by stronger enforcement. This result has an immediate
consequence on audit effort, which therefore increases and then decreases in enforcement
intensity.
We show that financial reporting quality does not always improve with greater enforcement
strength. It mainly depends on the proxy for financial reporting quality. One reason why earnings
management can be good is that, by managing earnings upwards, it corrects understatement errors
that arise in the accounting processes. Alleviating earnings management can then have a negative
effect. Another reason is that enforcement is limited in scope, compared to auditing, and therefore
crowding out auditing diminishes financial reporting quality. Summarizing these results, we establish
that strengthening enforcement (before systemic enforcement costs) is desirable but “too much”
enforcement can become detrimental.
We also examine several empirical measures that relate to enforcement effectiveness and derive the
following predictions that can guide empirical tests.
 Financial reporting quality (earnings quality): Our results suggest different predictions
dependent on the proxies used for earnings quality.
(i) If the proxy predominantly captures earnings management,15 stronger enforcement
increases financial reporting quality, because it unambiguously mitigates earnings
management.
(ii) If the proxy is comprehensive and captures both unintentional and intentional errors,16 the
predictions are ambiguous. Stronger enforcement tends to increase financial reporting quality
in firms or industries that have a low probability of success, in firms with more effective
internal controls, in firms with less conservative accounting, and vice versa.
 Financial reporting quality (comprehensive): Stronger enforcement tends to decrease financial

reporting quality the broader the scope of auditing is, relative to enforcement.
15
For example, this is the case with proxies based on the modified Jones model (Dechow, Sloan, and Sweeney
[1995]).
16
An example is the measure of Dechow and Dichev [2002].

 Audit quality and audit fees: Higher enforcement intensity increases audit quality and audit
fees in a weak enforcement regime and can decrease them otherwise. Higher penalties for the
auditor also increase audit quality and audit fees, if the accounting report is ex ante likely to
be high, and can decrease them otherwise. Higher enforcement penalties for the manager
always decrease audit quality.
 Enforcement actions: Higher enforcement intensity increases the number of enforcement

actions in a weak enforcement regime but can decrease it otherwise. Higher penalties for the
manager, auditor, or both decrease the number of enforcement actions.
Predictions like these can help design empirical tests to gain better insights into the interaction
between auditing and enforcement and their effects on financial reporting quality and audit quality.
They also suggest that the economic effects of strengthening enforcement will differ by industry and
by country.
Our model is intentionally parsimonious to examine and highlight interactions between earnings
management and audit effort in an equilibrium setting. It also makes it easy to define constructs
such as financial reporting quality and audit quality as well as several proxies related to these. There
exist several avenues for relaxing assumptions and extending the model structure to capture other
aspects of financial reporting. Our accounting processes are simple in that we consider random
errors and earnings management. Including effects from complying with accounting standards, real
earnings management, and the like can offer further insights. We model public enforcement as a
fixed technology, but it can select firms for investigation based on other information. Moreover,
enforcers may be guided by individual incentives. In reality, there exist additional institutions whose
purpose is to improve financial reporting quality. Examples are internal controls and governance,
audit committees, audit oversight, whistleblower or media reports, and private litigation. They are
likely to interact with auditing and public enforcement. Finally, while we are interested in financial-
reporting and audit quality, we do not consider the task of a securities regulator who oversees public
enforcement. The regulator may be more interested in social welfare effects that result from the
design of the enforcement system. Social welfare depends on real effects of accounting and the
costs of enforcement broadly.
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Appendix
Summary of notation
a Productive effort by manager, a  {aL, aH}

A Audit fee
AQ Audit quality
bj Earnings management: probability of report mi given yj, i, j = L, H and i ≠ j
CA Cost of enforcement action to auditor
CM Cost of enforcement action to manager
CO Cost of enforcement action to owner
f Probability of enforcer to detect y
FRQ Financial reporting quality (including intentional and unintentional errors)
(1 – probability of ri ≠ xi)
FRQEM Financial reporting quality (including intentional errors) (1 – probability of ri ≠ yi)
gj Audit effort: probability of observing x given report mj
g Minimum audit effort
k Scaling factor of cost of audit effort
m Preliminary report of manager, m  {mL, mH}
p Probability of high outcome xH given high effort aH
q Probability of high outcome xH given low effort aL
Q Condition that earnings management is “good” or “bad”
r Audited financial report, r  {rL, rH}
s Manager’s bonus
UA Utility of auditor
UM Utility of manager
UO Utility of owner
v Scaling factor of disutility of earnings management b
V Disutility of manager for aH
x Productive outcome, x  {xL, xH}
y Signal from accounting system, y  {yL, yH}
 Probability of report yL given xH (-error)
 Probability of report yH given xL (-error)
 Conservatism parameter

Proof of Lemma 1
To prove that bH = 0, consider the manager’s utility conditional on yH (gross of productive effort and
enforcement costs),
1
E[U M yH ]  prob(rH yH ) s  vbH2 ,
2
where prob(rH yH )  (1  bH )  bH gˆ L . We have

prob(rH yH )  gˆ L  1 < 0
bH
because gˆ L < 1. A necessary condition for bH > 0 is that this derivative is positive (enforcement costs
M
can only reduce E[U yH ] further), which cannot be true. Therefore, bH = 0.
Consider bL next. The manager maximizes her expected utility with respect to bL,
v
E[U M aH , yL ]  prob(rH yL ) s  bL (1  gˆ H ) fC M  V  bL2
2
v
 bL (1  gˆ H )  s  fC M   V  bL2
2
 C 
M
v 2
 sbL (1  gˆ H ) 1  f   V  bL .
 s  2
The first-order condition is
  CM 
E[U aH , yL ]  s(1  gˆ H ) 1  f
M
  vbL  0 ,
bL  s 
s  CM 
which implies bL  (1  gˆ H ) 1  f   0.
v  s 
The inequality holds because fCM < s and gˆ L < 1. To ensure that bL < 1 we assume s/v is sufficiently
small. 
Proof of Lemma 2
If the auditor observes mL, given conjecture bˆH  0 , he correctly anticipates that the enforcer will
never find an error because mL = yL. Therefore, prob(error mL )  0 , and the auditor faces no cost of
enforcement. Consequently, the auditor conducts the minimum audit effort gL = 0.

If the auditor observes mH, there is the risk that the enforcer identifies an error, which occurs if he
does not find out y (so that r = rH = mH) but the enforcer detects y = yL. The conditional probability of
an error is
prob(error mH )  prob( yL mH )(1  g H ) f ,
prob(yL )bˆL
where prob(yL mH )  , which is greater 0 if bˆL  0 . The auditor’s
prob(yL )bˆL +prob(yH )
conditional expected utility is
k 2
U A  mH   A  g H  prob( yL mH )(1  g H ) fC A .
2
The first derivative with respect to gH equals

U A  mH   kg H  prob( yL mH ) fC A ,
g H
and setting it equal to 0, the optimal audit effort gH is
CA
g H  prob( yL mH ) f 0,
k
if f > 0, and our assumption that CA/k < 1 ensures gH < 1. 
Proof of Proposition 1
We prove existence and uniqueness of an equilibrium in the feasible range for bL and gH using a
fixed-point argument. From Lemma 1,
s  CM 
bL  (1  gˆ H ) 1  f .
v  s 
That is, bL is linear and strictly decreasing in gˆ H . The boundaries are
s  CM 
 1  f  for gˆ H  0
bL   v  s 
 0 for gˆ H  1.

CA
According to Lemma 2, g H  prob( yL mH ) f with boundaries
k


 0 for bˆL  0
gH  

A
prob( yL ) f C k for bˆL  1.
Note that g H is strictly increasing and concave in bˆL because
g H prob  yL  prob  yH  fC A
 0
bˆ  prob  y  bˆ +prob  y 
2
L
k
L L H
prob  yL  prob  yH 
2
2 gH fC A
and  2  0.
bˆ 2  prob  y  bˆ +prob  y 
3
L
k
L L H
The two reaction functions bL ( gˆ H ) and g H (bˆL ) are monotonic and continuous; hence, the
function g H  bL ( gˆ H )  is also continuous and maps gˆ H  [0,1] into g H [0,1] due to
bL ( gˆ H ) [0,1] . Therefore, Brouwer’s fixed point theorem implies that a fixed point of
g H  bL ( g H )  exists for g H [0,1] . This fixed point constitutes an equilibrium, proving existence.
Uniqueness follows from the negative slope of the linear function bL and increasing and convex
function gH.
* *
Next, we derive the explicit solutions for the equilibrium strategies bL and g H . We start with the
manager’s optimal bias,
s
bL  (1  gˆ H )(1  f CM
s )  .
v
s
Defining T  f CM
s  1  0 , rewrite bL as bL  T ( gˆ H  1) . Solving for gˆ H yields
v
v
bL T
gˆ H  s .
T
The optimal gH given bˆL is
1 fC A
gH  .
1  prob(yL ) k
1+
prob(yL )bˆL
Equating gH = gˆ H yields

v 2   fC A  v prob(yH )  prob(yH )
bL  T   1   bL  T  0.
s   k  s prob(yL )  prob(yL )
T2
T1 T0
T1  T12  4T0T2
The solution of the equation T2bL  T1bL  T0  0 is bL 
2
. The terms Ti depend on
2T2
exogenous parameters, where T2 > 0 and T0 < 0 (due to T < 0) and the sign of T1 is indeterminate.
However, T0 < 0, implies T12  4T0T2  T1 . Therefore, regardless of the sign of T1, bL must be the
positive root because bL < 0 is not feasible.
The explicit solution for g H follows from
prob(yL )bˆL fC A
gH 
prob(yL )bˆL +prob(yH ) k
 fC A 
or prob(yL )bˆL  g H    g H prob(yH )  0.
 k 
Inserting bˆL = bL yields
s  fC A 
prob  yL  T ( gˆ H  1)  g H    g H prob  yH   0
v  k 
 prob  yH  v  fC A   CA
Tg H2   T   1  g H  Tf  0.
 prob  y L  s  k   k
T3
T4
This expression is a quadratic equation Tg H  T4 g H  T3  0 with solutions

2
T4  T42  4TT3

gH  . With T < 0 we have T3 < 0 and T4 > 0. Moreover, T4  4TT3  T4 . A
2
2T
solution in real numbers requires T4  4TT3  0 , i.e., T4  4TT3 . This must hold as there exists a
2 2
* *
unique equilibrium (bL , g H ) .
To determine the feasible root for gH, we rewrite the function that implicitly defines gH as
Tg H2  T4 g H  T3  0 and obtain g H2  (T4 / T ) g H  f CA
k  0 . According to Vieta’s rule, the product
 
, i.e., g H g H  f
A A
CA
of the two roots equals f C
k
C
k . This implies that one solution is larger than f k ,

which is the solution g H with the negative root due to T4 > 0 and T < 0 (for the negative root, the
numerator of gH is more negative leading to a larger value for gH by dividing through T < 0). However,

CA
an audit level gH > f k is not consistent with the auditor’s first-order condition as the maximum
possible audit level is prob  yL  f CA

k f CA
k if bL = 1. Hence, only the positive root is relevant.
Finally, consider the special case T = 0, where both numerator and denominator of g H are zero and
the quotient is not properly defined. If T = 0 then T3 = 0, T4 > 0, and inserting this into
Tg H2  T4 g H  T3  0 yields g H  T3 T4  0 .
Finally, a mixed-strategy equilibrium does not exist because the auditor’s expected utility is strictly
concave for any bL. 
Proof of Propositions 2, 3 and Corollary 3

We prove Propositions 2, 3 and Corollary 3 together because they follow from the same technique
of proof. To save notation, we drop the asterisk in the equilibrium strategies.
Consider first a variation of the equilibrium bL. As shown in the proof of Proposition 1, it is implicitly
prob(yH )  fC A  v  prob(yH ) 
defined by B  T2bL  T1bL  T0  0 , where T0  T
2
, T1  T   1   ,
prob(yL )  k  s  prob(yL ) 
v
T2  , and T  f CM
s  1 . The total differential with respect to parameters j = s, f, C M and CA/k is
s
1
B B bL b B  B 
 0 L    ,
j bL j j j  bL 
B  T  T 2  4T T 
where  2T2bL  T1  2T2  1 1 0 2
  T1  T12  4T0T2  0 . Thus,
bL  2T2 
 
 b   B 
sign  L   sign   for each j.
 j   j 
Variation of f:
B  CA  fC A  C M  prob  yH  C M
 bL   T   1 
f  k  k  s  prob  yL  s
 
 CA CM  fC A   prob  yH  C M
 bL   T 1     0.
 k s  k   prob  yL  s

 0 
b
T  0 implies B  0 and L  0 .
f f

Variation of CM:
B f  fC A  f prob( yH ) bL
 bL   1   0 , implying  0.
C M
s k  s prob( yL ) C M
Variation of CA and k:
B bL
  fTbL , implying  0 since T  0 .
(C / k )
A
(C A / k )
Variation of s:
 
B v  v  prob(yH )  C  fC
M A
 C M  prob(yH ) 
  2 bL2  bL  2    f   1    f    0,
s s  s  prob(yL )  s2  k  s 2  prob(yL ) 
 0 
bL
implying  0.
s
Consider next a variation of the equilibrium gH. As shown in the proof of Proposition 1, gH is implicitly
CA prob  yH  v  fC A 
defined by G  Tg H  T4 g H  T3  0 , where T3  Tf
2
, T4  T   1 ,
k prob  yL  s  k 
and T  ( f CM
s  1) . The total differential with respect to parameters j = s, f, and CA/k is
1
G G g H g G  G 
 0 H    ,
j g H j j j  g H 
G  T  T 2  4TT 
where  2Tg H  T4  2T  4 4 3
  T4  T42  4TT3  0 . Therefore,
g H  2T 
 
 g   G 
sign  H   sign   for each j.
 j   j 
Variation of f:

G C M 2  CA C M  fC A   C A  CM 
 gH  gH   T   1    T  f 
f s  k s  k  k  s 
CM 2 C A fC A C M CM
 gH  T 1  g H   1  g H   g H
s k k s s
C 
A
C M
 C 
M
 1  g H   2 f  1  g H .
 k  s  s 
0
M
G g
If f  1
2 (s C M ) , then M < 0, which implies  0 and H  0 . If f  1 2 (s C M ) , the term
f f
 2 f C M
s  1
k

CA
 0 , and the sign of M is indeterminate. There always exists a range of the
0
parameter f such that M > 0. To see this, ignore for the moment the restriction f ≤ 1, consider the
case f  s C M  1 which implies bL  0 and therefore g H  0 . It then follows that
G g
M  C A k  0 implying  0 and H  0 . Due to continuity, M must be positive in a range of
f f
f  s C M and there exists f0  s C M such that M ( f0 )  0 , i.e., g H attains a maximum at f 0 .
More specifically, observe that such f 0 requires
CA  CM  CM 1 s k 
M ( f0 )  2
 0 f  1  g
 H 0  f  0  f0   M  g H  f0  A  .
k  s  s 2C C 
Define
1 s k 
F ( f )  f   M  gH ( f ) A  .
2C C 
 
For f = 0, the audit effort g H ( f  0)  0 and F ( f  0)   1 2 s C M  0 . For f  s C M , we

have F f  s C M   1
2  s C   0 due to g  f  s C
M
H
M
  0 . Since F is continuous in f, the
intermediate value theorem implies that there exists f 0 such that F  f 0   0 . Moreover, f 0 is
unique because
  1 2
 
2 gH   2G  2G g H   G  G  G    2G  2G g H 
  2         
f 2  f f g H f   g H  f  g H   g H f g H2 f 
f  f0
  
  0 at f 0   0 at f 0   0 at f 0 
1
 2G  G 
 2    0.
f  g H 

 2G C A CM 2 gH
 2 1  g H   0 , which implies  0 . Because this holds for each local
f 2 k s f 2 f  f0
extremum, f0 must be the unique maximum; otherwise, there would exist a minimum in the relevant
range of f, which cannot be the case.
This proves the existence of f 0 such that g H achieves its unique maximum at
1
2 s C   f
M
0  s C M . If f 0  1 , then the maximum is outside the feasible range for f and
G
> 0 for any f [0,1].
f
Variation of CM:
G 2 f f  fC A  f fC A
 gH  gH   1 
C M s s k  s k
f f fC A
 g H  g H  1  1  g H 
s s k
f  fC A 
  g H  1  g H    0.
s k 
0
0
g H
This implies  0.
C M
G g H
Variation of CA and k:   g H fT  fT  fT 1  g H   0, implying  0.
(C / k )
A
(C A / k )
Variation of s:
G CM  v prob  yH  C M  fC A   C M fC A
  g H2 f 2  g H  2 f 2   1   f 2
s s  s prob  yL  s  k  s k
CM v prob  yH  C M fC A
  g H  g H  1 f 2  g H 2   g H  1 f 2
s s prob  yL  s k
C M  fC A  v prob  yH 
  g H  1 f 2 
 gH   gH 2  0.
s  k  s prob  yL 
0
0
g H
Therefore,  0. 
s

FRQ is defined as
FRQ  1  prob(xH , rL )  prob( xL , rH )
where prob(xH , rL )  p 1  bL* (1  g H* ) 

prob(xL , rH )  (1  p)(1   )bL* (1  g H* )  (1  p)  (1  g H* )
and
 (1  p)    bL* (1   )  (1  g H* ).
Substituting these terms yields
FRQ  1   p  (1  p)   bL (1  g H )  p  (1  p)(1   )  .
The derivative with respect to f is
FRQ   bL (1  g H ) 
 
  p  (1  p)(1   ) 
f f
  bL (1  g H ) 
 Q.
f
Note that
 prob(yL )bL CA 
bL 1  g H   bL 1  
f 
 prob(yH )  prob(yL )bL k 
b 
prob(yH )  prob(yL )bL 1  f  CA
k 
L
prob(yH )  prob(yL )bL

prob(yH )  prob(yL )bL 1  f CA
k .
prob(yH )
 prob(yL )
bL
FRQ
bL strictly decreases in f, and so does bL 1  g H  . Therefore, > 0 if Q > 0 and vice versa.
f
FRQ FRQ
According to Proposition 3, bL strictly decreases in CA and in CM. Therefore, A > 0 and
C C M
> 0 if Q > 0 and vice versa. 
Proof of Corollary 2
As shown above in the proof of Proposition 2 and 3, equilibrium audit effort results from solving
G  Tg H2  T4 g H  T3  0 , and it follows that

 g   G 
sign  H   sign  .
     
Let P denote the probability ratio,
prob  yH  p 1     1  p    
P  .
prob  yL  p  1  p 1     
In the expression of G only the term
prob  yH  v  fC A 
T4  T   1
prob  yL  s  k 
G v P
depends on P. Taking the derivative of G with respect to  yields  gH  0 , implying
 s 
0
g H
 0.

s  CM 
Since equilibrium earnings management is bL  (1  g H ) 1  f  , the fact that g H   0
v  s 
implies
bL s C M  g H
  1  f   0.
 v s  
Therefore,
  bL 1  g H   bL g
 1  g H   H bL  0.
  
The statements in the corollary follow directly from
FRQ  1   p  (1  p)    bL (1  g H )  (1  p)(1   )  p 

 1   p  (1  p)    (2 p  1)   bL (1  g H )  (1  p)(1   )  p   (1  2 p)  .
and the derivative
FRQ 
 bL 1  g H  


 1  2 p  1  bL 1  g H  
 
 
Q . 

Part (i): g H ( f  0)  0 since there is no enforcement risk, and we also have g H ( f  s C M )  0 as
there is no earnings management. Thus, prob(error) is zero for these boundary cases but strictly
positive for all 0 < f < s/CM, implying that due to continuity there must exist 0 < f1 < s/CM such that
prob(error) attains a maximum.
Rewriting prob(error) by inserting the equilibrium expression for bL yields
s 2 CM 
prob  error   prob  yL  bL 1  g H  f  prob  yL  1  g H   f  f 2 .
v  s 
The first-order condition is

prob  error  
f
s    CM   2 C
M
 g H  
prob  yL   1  g H  1  g H  1  2 f

  2 f  f     0.
v    s   s  f  
To ensure this condition holds, the term in brackets must be zero. Consider f  1 s
2 CM , where
1 s
2 CM  f 0 . We have
  CM    g H g H
M
2 C 1 s
 H 
1  g 1  2 f 
 
s  
2 f  f 
s  f

2 CM f
0.

 0 due to f  f 0
s
Thus, there must exist f1  such that prob(error) attains a maximum. If 1 < f1, this maximum
2C M
is actually not relevant and prob(error) strictly increases for f   0,1 .

Part (ii): As shown in the proof of Proposition 4 that bL 1  g H  strictly decreases in C M
and CA,
implying

prob(error)  prob( yL ) f

 bL 1  g H 
 0 and

C M C M
0

prob(error)  prob( yL ) f

 bL 1  g H 
0. 

C A C A
0

 
Part (i): Note that g H  f  0   g H f  s C M  0 , implying AQ( f  0)  AQ( f  s C M )  0 .
Furthermore, AQ(f) > 0 for all 0  f  s C M . Because AQ is differentiable (and thus continuous) in
f, there exists 0  f 2  s C M such that AQ attains its maximum at f 2 . The first-order condition is
AQ  f 2  prob  mH   g 
 g H  prob  mH  H  0 .
f f f
 0 due to bL f  0
The relation f 2  f 0 cannot hold since g H  f 0  f  0 at f0 and g H f  0 for all f > f0 (see
Proposition 2 (ii)), implying
AQ
 0 for all f  f 0 .
f
Thus, it follows that f 2  f 0 . If 1  f 2 , then the maximum is not attained over the relevant range
and AQ strictly increases for all f  [0,1].
Part (ii): Substituting for
 prob(yL )bL* CA
g 
H f
prob(yL )bL* +prob(yH ) k
we rewrite AQ as
CA
AQ  prob(yL )bL f .
k
CA
Since CM has only an effect on bL and there are no other effects of CM in AQ  prob(yL )bL f ,
k
AQ
we have  0.
C M
Part (iii): First, since AQ = 0 if CA = 0 and AQ > 0 for all 0  C  k , it follows that AQ strictly
A
increases in CA if CA is small. Second, the behavior of AQ depends on the behavior of the term bL R
where we use R  C A k to save notation. Inserting for bL yields
s   CM 
b R  1  g H  1  f

L R,
v  s 
hence it is sufficient to consider the behavior of 1  g H R .  

If AQ attains a maximum with respect to R, the first-order condition implies

 1  g H  R   1  g   g R  0


H
 1  g H 
g H
R.
H
R R R
Since g H  prob  yL mH  fR , we have
g H prob  yL mH 
 prob  yL mH  f  fR .
R R
 0 due to bL R  0
g H prob  yL mH  2
Since R  g H  fR , substituting in the first-order condition yields
R R
g H prob  yL mH  2
1  g H  R  2 g H  fR .
R R
0
Thus, if g H  1
2 , AQ cannot attain a maximum with respect to R. This will clearly be the case if the
largest possible equilibrium audit effort does not exceed ½. According to Proposition 3 (iii), g H
strictly increases in R for each f, thus we only have to consider R = 1 in that calculation. Furthermore,
Proposition 2 (ii) implies that there exists f0 such that g H attains its maximum with respect to f,
implying that the largest possible equilibrium audit effort results from applying
f  min 1; f0 ( R  1) where f 0 ( R  1) is the value of f0 which results when inserting R = 1. If
f0 ( R  1)  1 , then the audit effort always strictly increases in f  [0, 1] and the maximum is
reached at f = 1.
Let g H and bL denote the equilibrium strategies corresponding to f and R = 1. Then AQ will not
attain a maximum with respect to R if
prob  yL  bL 1 prob  yH 

g  
f    bL  2 f  1  0 .
prob  yH   prob  yL  bL prob  yL 
H 
2
The last inequality follows from
 s  1
f 0  R  1  1  M  g H  f 0  R  1   
2 C  2
due to s  CM. 

Part (i): The existence of a maximum for A in the range 0  f  s C M follows from applying the
same steps as in Proposition 7 (i). Rewrite A as
k k
A  prob  mH  g H  2  g H   AQ  2  g H  .
2 2
The first partial derivative of A with respect to f is
 
A k  prob  mH   g   k  AQ g  
  g H  2  g H   prob  mH  2 1  g H  H    2  g H   AQ H .
f 2  f f  2  f f 
 0 
f3  f 0 is not possible for a maximum since g H f  0 for all f  f 0 implying A f  0 due to

the first version of the derivative. f 2  f3  f 0 is also not possible because AQ f  0 and
g H f  0 for f   f 2, f 0  making A f  0 as is evident from the second version of the
derivative. Thus, the maximum audit fee is attained at some f 3 with f3  f 2  f 0 . If f3  1 , then
the maximum is actually not attained for f   0,1 and A strictly increases in f.
Part (ii): Since bL and g H strictly decrease in CM, we obtain
 
A k  prob  mH   g H 
H  H   H  H M
 
 g 2  g  prob m 2 1  g  0.
C M 2  C M C 
 0 0 
Part (iii): Since g H  0 if CA = 0 and g H  0 for all 0  C  k , it follows that A strictly increases in
A
CA if CA is small. To derive a more specific condition, we apply the procedure as in the proof of
Proposition 7 (iii). Rewrite A by inserting the equilibrium expression for g H to obtain (we use again
R  Ck )
A
k
A prob  mH  g H  2  g H 
2
k

 prob  yL  bL fR  2  g H 
2

k
 prob  yL  f bL R  bL R 1  g H   .
2

The behavior of A with respect to R depends only on the behavior of the term in square brackets.
From Proposition 7 (iii), we know that bL R strictly increases in R if the condition on the probability
ratio is met. Considering the second term and substituting for bL yields
s CM 
b R 1  g   1  f

L

H  1  g H  R ,
 2
v s 
 
 2
implying that it is sufficient to consider 1  g H R . Applying the same steps as in the proof of
Proposition 7 (iii), this term always strictly increases in R if
prob  yL  bL 1 prob  yH 


g  f    bL  3 f  1  0 .
prob  yH   prob  yL  bL prob  yL 
H 
3
Since
bL  3 f  1  bL  2 f  1 ,
this condition is stricter than the corresponding condition for bL R . Thus, if the new condition for the
probability ratio holds, both bL (1  g H ) R and bL R strictly increase in R implying that audit fee A
strictly increases in CA. 
The owner’s utility is
E[U O aH ]   (1  p) xL  pxH   prob(rH )s  A  prob(error)C O .
The expected outcome is constant, given a = aH. We first prove that each of the three cost
components increases in the bonus s, implying that the owner prefers the lowest s such that the
manager’s incentive compatibility constraint is satisfied.
Expected compensation is
 
prob  rH  s   p 1     1  p    p  1  p 1    bL 1  g H   s .
 
We have
prob  rH  s prob  rH 
 prob  rH   s ,
s s
where
prob  rH 
  p  1  p 1    

 bL 1  g H  
 0 . The inequality follows from
s s
Corollary 3.

k *
The equilibrium audit fee is A  prob(mH ) g H (2  g H* ) , where
2
prob  mH   p 1     1  p     p  1  p 1    bL .
The derivative is
A prob  mH  k  g 
 g H  2  g H   prob  mH  k 1  g H  H  0 .
s s 2 s
Since both prob  mH  (through bL ) and g H strictly increase in s (Corollary 3), the audit fee strictly
increases in s as well.
Finally, the owner’s expected cost of enforcement is
prob  error  C O  prob  yL  bL 1  g H  fC O .

Since bL 1  g H  strictly increases in s, the expected enforcement cost to the owner also strictly
increases in s.
Hence, the optimal s is the lowest s that satisfies the incentive compatibility constraint. The
manager’s utility conditional on the actions is
v
E[U M aH ]  prob(rH ) s  V  prob( yL ) bL*2  prob( yL )bL* (1  g H* ) fC M
2
 
 v
 prob  yH  s  prob  yL   bL 1  g H  s 1  f Cs  bL2   V

M
2 
v
 prob  yH  s  prob  yL  bL2  V ,
2
where we substitute for bL . Similarly, the expected utility for aL is
v
E[U M aL ]  prob(rH aL ) s  prob( yL aL ) bL*2  prob( yL aL )bL* (1  g H* ) fC M
2
v
 prob  yH aL  s  prob  yL aL  bL2 .
2
Note that the optimal earnings management is independent from the productive effort choice and
its effect depends only on the probability of yL with which earnings management is undertaken.
Because the auditor does not observe the manager’s action choice, audit effort is also independent
from the productive effort, the auditor chooses his effort conjecturing aH.
The difference of both expected utilities is

v
  
 U M aH   E U M aL   s prob  yH   prob  yH aL   bL2 prob  yL   prob  yL aL   V
2

 v 
  p  q 1       s  bL2   V .
 2 
The optimal bonus requires that this difference is zero, resulting in
V v
s   bL2 .
 p  q 1      2
Define
 v 
H   p  q 1       s  bL2   V  0 .
 2 
Using the implicit function theorem, we obtain for any parameter j
1
H H s s  H   H 
 
j s j
0
j
      j  f ,C M
,C A k 
 j   s 
We have
H  bL 
 1  v   p  q 1      .
s  s 
Rewriting equilibrium earnings management
s 1
b  1  g H   fC M 1  g H 

L
v v
we obtain
bL g H
v   1  g H  

 fC M  s  .
s s
Substituting this term in the derivative of H yields
H   M g H 


s 
g
 H   s 
 fC    p  q 1       0
s 
 s   H 
because 0 ≤ f ≤ 1, CM < s* and g H s  0 . Thus, sign    sign  .
 j   j 
Setting j = f yields

H bL
   p  q 1      v 0
f f
bL s 
because  0 . Thus,  0.
f f
Given the qualitatively similar relation between bL and CM as well as CA/k, we have
s s
 0 and  0. 
C M  C A k 
Part (i) follows from
dbL bL bL s

  ,
dj j s j
where j = f, CM, or CA/k, using the partial derivatives stated in Propositions 2, 3, 9, and Corollary 3.
Part (ii): To prove the effect of f on audit effort note that g H  0 if f = 0; if f  s C M  1 for a
given s  1, g H  0 because bL  0 . Next, since s* strictly decreases in f, there is an fˆ such that
fˆ  s ( fˆ ) C M  1, bL ( fˆ )  0 and g H ( fˆ )  0 . Due to differentiability and continuity of g H ,
there exists 0  f 4  fˆ where g H achieves its maximum (which is not necessarily within [0, 1], as in
Proposition 2 (ii)). At this point we have
dg H  f 4 , s  f 4   g H  f 4 , s  f 4   g H  f 4 , s   f 4   s
   0,
df f s f
0 0
and it is apparent that at f4, the direct impact of f on audit effort is
g H  f 4 , s  f 4  
 0.
f
Furthermore, consider any combination f and s ( f ) such that
g H  f , s ( f ) 
 0,
f

i.e., there is crowding out with a fixed bonus s ( f ) . It follows that there is also crowding out with
endogenous bonus s*(f) as

dg H  f , s ( f )  g H  f , s  ( f )  g H  f , s  ( f )  s
   0.
df f s f
0 0 0
Part (iii): The statement follows from
dg H g H g H s
   0,
dC M C M s C M
0 0 0
using Propositions 3, 9, and Corollary 3.
Part (iv): Rewrite
1
bL 
v
1  g H  s  fC M   vbL  1  g H  s  fC M  .
Solving for g H gives
vbL
g H  1  .
 s  fC M 
Totally differentiating this term with respect to R ≡ CA/k yields
 db s 
  v  s  fC M  L  vbL 
dg dR R
H
  .
dR 
  s  fC 
 M 2


 
The sign of dg H dR depends on the sign of the numerator,
dbL  s

v  s  fC 
 M
 vbL .
dR R
Using
bL
v
s R bL s  bL 
  v  1  v 
R b R R  s 
1 v L
s
from the proof of Proposition 9, expanding this expression yields

dbL s  b b s   s

v  s  fC M   vbL  v  s   fC M   L  L   vb L
dR R  R s R  R
 s  bL  bL s   s

M s

 s

  s  fC M    1  v   v   vbL   s 
 fC   vbL
 R  s  s R  R R R
s  s  

R
 s  fC M
 vb L


R
g H  s  fC M  .
It follows that
 
M dbL  s

  s   
dg H  v  s  fC   vbL   g H  s  fC M  
  dR R     R 
 s  fC M 2
  s   fC M 
2
dR  
 
   
   
s g H
 0
R  s  fC M 

because s* R  0 , s  C , f ≤ 1 and g H  0 .
M


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Effects of Increasing Enforcement on

Financial Reporting Quality and Audit Quality

RALF EWERT* AND ALFRED WAGENHOFER*

JEL codes: G38; M41; M42; M48

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2.1. Production technology

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2.2. Accounting system

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Figure 2 summarizes the sequence of events.

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 Owner hires manager and engages auditor

 Manager provides productive effort a

 Manager observes accounting signal y and engages in earnings management b

 Preliminary report m is released

 Audited report r is published

 Manager receives contractual compensation s(r)

Lemma 1: Optimal earnings management is bH = 0 and

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prob(error) = prob(yL)bL(1 – gH)f . (4)

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the conjectures are fulfilled, i.e., bˆi  bi and gˆ j  g j .

The next proposition establishes a unique equilibrium.

4. Effects of strengthening enforcement on equilibrium strategies

4.1. Enforcement intensity

Proposition 2: Increasing enforcement intensity f has the following effects:

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4.2. Enforcement penalties

Proposition 3: Increasing enforcement penalties has the following effects:

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5. Effects on accounting outcomes

FRQ  1  prob(rL )prob(xH rL )  prob(rH )prob(xL rH )

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FRQ  1   p  (1  p)    bL (1  g H )  (1  p)(1   )  p  . (10)

Note that the ex ante probability of a report yL is

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Figure 4: Enforcement intensity and financial reporting quality

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Corollary 1: FRQ is likely to decrease in f, CA, and CM (i.e., Q decreases),

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FRQ EM  1  prob(rL )prob(yH rL )  prob(rH )prob(yL rH )

where prob(yH , rL )  0 and prob(yL , rH )  (1  p)bL (1  g H ) .

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5.2. Likelihood of enforcement actions

prob(error)  prob( yL )bL* (1  g H* ) f .

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5.3. Audit quality and audit fees

where f  min{1; f 0 ( Ck  1)}.

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The impact of an increase in CA on audit quality is subtle. Since AQ = 0 if f = 0 or CA = 0 but is strictly

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where f  min{1; f 0 ( Ck  1)}.

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6. Optimal bonus contract

Corollary 3: Increasing the bonus s has the following effects:

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The owner chooses s to maximize the expected utility,

E[U O aH ]  (1  p) xL  pxH  prob(rH )s  A  prob(error)C O . (15)