Financial reporting, auditing, analyst scrutiny, and investment efficiency

Abstract

This paper presents a model in which a firm's owner, an auditor, an analyst, and outside investors strategically interact. Along the owner–auditor–analyst monitoring chain, the auditor examines the financial report prepared by the owner, and the analyst scrutinizes the auditor as well as the owner by means of a stock recommendation. Audit quality and the owner's misreporting behavior jointly determine financial statement reliability, which together with analyst scrutiny affects the information available to outside investors about the firm's type and hence investment efficiency. I show how the presence of the analyst affects the strategic interaction between the owner and the auditor, and how the analyst's independence affects financial statement reliability, investment efficiency, and the consequences of changing other regulations. Under some mild conditions, the consequences of enhancing the analyst's independence are intended: alleviating financial manipulation and improving audit quality, financial statement reliability, and investment efficiency. A surprising result emerges from the model that if the analyst is highly independent, enhancing the auditor's legal liability can impair investment efficiency. My results further reveal that the position of the direct target of a regulation along the monitoring chain endows the regulation with important systematic characteristics. My analysis also suggests empirical and regulatory implications.