Why Accounting Regulation? An Interplay between Investor Experience and Managerial Manipulation

In this paper, I ask the question whether accounting regulation is beneficial or detrimental from the angle of investors’ information processing behaviors. It is well established that managers engage in various kinds of reporting manipulations, and the rewards from manipulations are determined by how investors, guided by their experiences, react to reported information. Based on the view that accounting disciplines unmanipulated patterns in financial information, I analyze managers’ manipulation incentives in an unregulated economy versus in a regulated economy and examine the efficiency implications of accounting regulation, conditional on different types of investor experience. I find that 1) while accounting regulation generally improves investment efficiency, it can impair investment efficiency and lead to more managerial manipulations; 2) investor sophistication may, but not always, strengthen the effects of accounting regulation; 3) accounting regulation may induce investors to act more conservatively; and 4) optimal accounting regulation varies with investor experience and often features a corner level of stringency. A number of implications are also discussed