Financial Reporting Regulation in the Laboratory: A Case on Earnings Management

Using a controlled laboratory experiment, we examine how financial reporting regulations—limits on earnings management and auditing—affect disclosure quality and market efficiency. Our findings indicate that a tight limit and the possibility of an audit enhance the informativeness of earnings disclosures, leading to improved pricing efficiency while a weak limit deteriorates disclosure quality and pricing efficiency. Financial reporting regulations enhance disclosure quality via both constraining earnings management practices and inducing signaling behavior. Auditing more effectively boosts social welfare by suppressing manipulation, whereas limits trigger overinvestment in costly signal. Our results also shed light on previously contradictory empirical findings regarding financial reporting regulations. This paper was accepted by Marie Claire Villeval, behavioral economics and decision analysis. Funding: Y. Dai acknowledges support from the National Natural Science Foundation of China [Grants 72372163, 72132010, and 72273156] and the Fundamental Research Funds for the Central Universities [23wkqb10]. T. Bao acknowledges the financial support from the Ministry of Education (MOE) of Singapore Academic Research Fund Tier 1 Grant [RG121/23], NTU Centre for Computational Technologies in Finance (CCTF) and Alibaba-NTU Global e-Sustainability CorpLab (ANGEL). J. Zhu acknowledges the National Natural Science Foundation of China [Grants 72303170, 72141304, and 72201190], and the National Key Research and Development Program of China [Grant 2022YFC3303304]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.03361 .