Misreporting as Strategic Experimentation: Theory and Evidence
66 Pages Posted: 31 Dec 2019 Last revised: 10 Feb 2021
Date Written: November 1, 2019
Abstract
We propose a two-period model wherein two firms select the level of misreporting in the presence of a sequentially rational regulator, who weighs the benefits of correcting misreporting against an enforcement cost unknown to the firms. Each firm strategically experiments with misreporting to learn about that cost, while free-riding on the information revealed by the peer firm’s misreporting action. In response, the regulator bluffs with more aggressive enforcement in the first period. The model implies that misreporting increases with the mean of enforcement cost and regulatory spillover, decreases with the regulator's decision horizon, the observability of peer’s misreporting, and the cost correlation between firms, and is convex in regulatory uncertainty. A firm’s responsiveness to its peer’s past misreporting increases with peer observability and cost correlation. Empirical tests generally support the model's predictions.
Keywords: misreporting; strategic experimentation; enforcement cost; regulatory uncertainty; observability; accounting comparability; regulatory spillover
JEL Classification: D82, D83, G18, M41, M48
Suggested Citation: Suggested Citation