How Does Financial-Reporting Regulation Affect Market-Wide Resource Allocation?

Abstract

I investigate the impact of mandatory reporting and auditing of firms’ financial statements on industry-wide resource allocation. Using size-based reporting and auditing requirements for limited liability firms in 26 European countries, I document reporting regulation, mandating a greater share of firms in an industry to disclose a full set of financial statements, fosters a competitive and dispersed type of resource allocation in product and capital markets, but does not unambiguously improve the efficiency of resource allocation. By contrast, I find auditing regulation, mandating a greater share of firms to obtain a financial-statement audit, imposes a net fixed cost of operating on firms, deterring entry of smaller firms. I do not find any other effects of auditing regulation on industry-wide resource allocation in my setting. My findings suggest reporting regulation substitutes a transactional type of resource allocation based on public information for a relational one based on private information. This substitution, however, fails to spur economic growth. With respect to firms’ auditing, my findings suggest it lacks significant industry-wide externalities compensating for firms’ costs of mandatory auditing.

Keywords: financial-reporting regulation, disclosure, auditing, competition, resource allocation

JEL Classification: M41, M42, M48, K23