Journal of Accounting and Economics 65 (2018) 221–236

Contents lists available at ScienceDirect

Journal of Accounting and Economics

journal homepage: www.elsevier.com/locate/jacceco

Accounting standards, regulatory enforcement, and

innovationR
Volker Laux a,∗, Phillip C. Stocken b
a
University of Texas at Austin, United States
b
Dartmouth College, United States

a r t i c l e i n f o a b s t r a c t

Article history: We examine the effects of accounting standards and regulatory enforcement on en-
Received 16 June 2016 trepreneurial innovation and social welfare. When the entrepreneur issues a financial re-
Revised 12 September 2017
port that violates the accounting standards, a regulatory agency may detect the violation
Accepted 16 November 2017
and bring charges. We find that when regulatory penalties are relatively insensitive to the
Available online 20 November 2017
magnitude of the violation, optimal standards are sufficiently low that they induce full
Keywords: compliance, and increase as the intensity of enforcement increases. In contrast, when reg-
Accounting standards ulatory penalties are sensitive to the magnitude of the violation, optimal standards induce
Regulatory enforcement non-compliance and decline as the intensity of enforcement increases.
Innovation
© 2017 Elsevier B.V. All rights reserved.

1. Introduction

The optimal design of accounting standards and their enforcement has been much debated. More stringent accounting
standards and heightened regulatory enforcement are often viewed as key ingredients for facilitating investment efficiency.
For example, the Securities and Exchange Commission (SEC) has raised its enforcement activity and punishment of individ-
uals, more than doubling the median fine over the past decade (Eaglesham and Fuller, 2015). Conversely, venture capitalists
are concerned that stricter reporting standards and heightened regulation discourage entrepreneurial activity as it raises
the cost of investing in innovative projects. Indeed, in 2012, the US Congress enacted the Jumpstart Our Business Startups
(“JOBS”) Act that relaxed mandated disclosure and compliance obligations for “emerging growth companies” seeking public
financing (Dharmapala and Khanna, 2014). As technological innovation is vital for the continued growth of the economy
(Denning, 2015), understanding the influence of accounting standards and regulatory enforcement on innovation is impera-
tive.1

R
We thank Joanna Wu (editor) and Pingyang Gao (reviewer) for helpful comments and suggestions. We also thank Kris Allee, Anil Arya, Shane Dikolli,
Pingyang Gao, Yanmin Gao, Robert Goex, Mirko Heinle, Jeong Bon Kim, Lingmin Xie, Kathy Petroni, Canice Prendergast, Joshua Ronen, Richard Saouma,
Katherine Schipper, Lars Stole, Pete Wilson, and workshop participants at Boston College, University of Chicago, City University of Hong Kong, Burton
Workshop at Columbia University, Duke University, INSEAD, Michigan State University, New York University, Ohio State University, University of South
Africa, University of Utah 2014 Winter Accounting Conference, and the 8th Accounting Research Workshop in Basel for their valuable comments.
∗
Corresponding author.
E-mail address: volker.laux@mccombs.utexas.edu (V. Laux).
1
On this matter, when interviewed about winning the 2014 Nobel Prize in Economic Science, Jean Tirole remarked that “regulation is a complex subject
because it must be light enough to prevent entrepreneurship from being squelched, while ‘at the same time you need to have a state which is going to
enforce those regulations’ ” (Forelle and Horobin, 2014).

https://doi.org/10.1016/j.jacceco.2017.11.001
0165-4101/© 2017 Elsevier B.V. All rights reserved.
222 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

Our aim is to examine how the stringency of accounting standards influences innovation and how standards and the
enforcement of these standards interact. In our model, an entrepreneur expends research and development effort that can
lead to the discovery of a new project. If the entrepreneur discovers a project, she privately observes a signal that is infor-
mative about the project’s likelihood of success. The firm’s reporting system classifies this signal as being either favorable
or unfavorable. To warrant a favorable report, the signal must exceed an official threshold that Generally Accepted Account-
ing Principles (GAAP) dictate. A higher threshold represents a more stringent GAAP standard. Investors finance the project
only when the report is favorable, which can create an incentive for the entrepreneur to violate the standard and to send a
favorable report when in fact the signal lies below the GAAP standard.
A regulatory agency, such as the SEC’s Division of Enforcement, investigates the firm’s report with some probability. The
investigation probability is higher in environments with more intense regulatory enforcement. If the regulator discovers
that the report did not comply with the GAAP standard, the entrepreneur faces financial penalties, disbarment from serving
as an officer or director, and the loss of reputation. The entrepreneur’s expected costs of non-compliance entail a variable
component, which is increasing in the magnitude of the violation as measured by the difference between the signal and the
GAAP standard, and a fixed component, which does not change with the size of the violation.
We motivate these two distinct components of the penalty function by appealing to the primary anti-fraud provisions of
the federal securities laws. Under Section 10(b) of the Securities Exchange Act of 1934 and the related SEC promulgated Rule
10b-5, the SEC needs to prove a defendant’s intent to deceive when bringing enforcement charges, suggesting that it is more
likely to succeed when a violation is more egregious, as captured by the variable component. Under Section 17(a)(2) of the
Securities Act of 1933, the SEC does not need to prove a defendant’s intent to deceive when bringing charges, enabling the
agency to enforce violations regardless of their size, as captured by the fixed component.
Turning to the results, we first characterize the entrepreneur’s optimal reporting strategy. The entrepreneur issues a
favorable report whenever the signal exceeds a certain threshold, which we term the shadow threshold, and issues an
unfavorable report otherwise.2 As long as the GAAP standard is relatively weak, the entrepreneur fully complies with it, and
the shadow threshold equals the GAAP standard. When the GAAP standard is more stringent, however, the entrepreneur
chooses a shadow threshold below the GAAP standard and misclassifies all signals that lie between the shadow threshold
and the GAAP standard.
We then examine how the GAAP standard affects the entrepreneur’s incentive to search for innovative projects. Standards
that induce higher innovation activity are desirable because they also yield higher social welfare. To discuss the trade-offs
involved when setting standards, consider the highest possible standard that still induces full compliance. We refer to this
standard as the full-compliance threshold. Since the entrepreneur is fully compliant, she does not incur any regulatory
penalties when she seeks financing for a new project. The disadvantage of this standard, however, is that it is relatively
weak, so that the entrepreneur will issue a favorable report even for relatively low signals. As a consequence, the project
is sometimes financed even though its net present value is negative; that is, the entrepreneur overinvests in the project.
While this overinvestment is ex post optimal for the entrepreneur, it is ex ante detrimental because investors anticipate this
behavior and demand a higher return on their investment.
An increase in the GAAP standard above the full-compliance threshold has two conflicting effects on the entrepreneur’s
incentive to innovate. First, a more stringent accounting standard induces the entrepreneur to choose a higher shadow
threshold and thus reduces overinvestment. The greater investment efficiency benefits the entrepreneur ex ante because it
allows her to raise capital at a lower cost when the report is favorable. This effect, which we term the investment efficiency
effect, increases the entrepreneur’s expected value of discovering a new project, and hence, her incentive to innovate. Sec-
ond, pushing the GAAP standard above the full-compliance threshold induces the entrepreneur to violate the accounting
standard. Non-compliance leads to regulatory penalties, which reduce the entrepreneur’s payoff associated with uncovering
a new project. This effect, which we term the regulatory cost effect, reduces the entrepreneur’s incentive to innovate.
We find that when the fixed component of the non-compliance penalties is high relative to the variable component,
the GAAP standard that maximizes innovation and social welfare is the one that induces full compliance. Intuitively, an
increase in the GAAP standard above the full-compliance threshold results in misreporting and a relatively large increment
in regulatory penalties since the fixed component of the penalties is high. The entrepreneur also increases the shadow
threshold to reduce the extent of misreporting, but this increase is relatively small since the variable component of the
penalties is low. As a result, the regulatory cost effect dominates the investment efficiency effect, and accordingly, raising
the GAAP standard above the full-compliance threshold is counterproductive and reduces innovation incentives.
In this case, since the entrepreneur already complies with the GAAP standard, an isolated increase in the enforcement
intensity (i.e., an increase in the probability of regulatory investigation) does not change the entrepreneur’s behavior. More
intense enforcement, however, allows the standard-setter to increase the GAAP standard without creating incentives for
misreporting. A higher GAAP standard then improves investment efficiency and spurs innovation. Accordingly, when penal-
ties are mainly fixed, standard-setters ought to set more stringent standards in environments with more intense regulatory
enforcement.
Conversely, when the fixed component of the non-compliance penalties is low relative to the variable component, the
GAAP standard that maximizes innovation and social welfare exceeds the standard that induces full compliance. Although

2
The term shadow threshold is borrowed from Dye (2002).
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 223

an increase in the GAAP standard above the full-compliance threshold induces misreporting, the regulatory penalties are
initially fairly low because the fixed component of the penalties is low. The entrepreneur also increases the shadow thresh-
old, and this increase is relatively large because the variable component of the penalties is high. Accordingly, at the full-
compliance threshold, the investment efficiency effect dominates the regulatory cost effect, and an increase in the GAAP
standard spurs innovation. As the GAAP standard becomes increasingly stringent, however, the investment efficiency effect
weakens and the regulatory cost effect strengthens. The optimal standard is the one that balances these two effects, leading
to both non-compliance and overinvestment in equilibrium.
Contrary to the case with mainly fixed penalties, when penalties are mainly variable, standard-setters ought to choose
less stringent standards in environments with more intense regulatory enforcement. More intense enforcement causes the
regulatory cost effect to dominate the investment efficiency effect. Accordingly, the standard-setter optimally responds by
lowering the GAAP standard to reduce the expected regulatory cost, thereby restoring the balance between the two effects
and promoting innovation.
The analysis highlights that the relative magnitudes of the fixed and variable regulatory penalties play an important
role because they affect whether optimal standards induce compliance or non-compliance and whether optimal standards
and regulatory enforcement are positively or negatively related. Our analysis suggests that standard-setting and regulatory
enforcement require careful coordination to heighten innovation and social welfare.
The primary antecedent of our paper is Dye (2002). Similar to the present study, Dye (2002) defines an accounting stan-
dard as bisecting the state space to yield a favorable and an unfavorable report, reflecting the binary nature of accounting
classifications. Dye (2002) examines how standards affect actual reporting behavior, how standards are expected to evolve,
how errors in the parameters characterizing the environment affect standards, and how standard-setters strategically choose
standards when anticipating their effect on reporting behavior. Using a similar accounting framework, Chen et al. (2010) ex-
amine optimal standards when accounting information is used to motivate the agent to take two costly actions that increase
expected payoffs as well as reduce the variance of the payoffs. Gao (2014) finds that optimal recognition standards feature
a trade-off between a statistical effect, which depends on the recognition errors a standard induces, and a strategic effect,
which is driven by the agent’s incentive to manipulate evidence ex ante. Kaplow (2011) extends the models of law enforce-
ment by treating the burden of proof threshold necessary to impose sanctions as a policy choice along with enforcement
effort and level of punishment. He shows that raising standards can increase the likelihood of inappropriately punishing be-
nign acts. Our study is also related to Laux and Ray (2017) who show in an optimal contracting setting that linking incentive
pay to a more conservative performance measure (which cannot be manipulated) lowers the cost of inducing the manager
to search for new projects and make appropriate investment decisions.
Our work differs from the aforementioned studies in several ways. First, we seek to understand how accounting stan-
dards and the regulatory enforcement of these standards influence entrepreneurial activity. In this regard, the Organization
of Economic Cooperation and Development suggests that innovation is enhanced by the identification and dissemination of
best practices in financial reporting (OECD, 2010). We find that stricter GAAP standards either increase or decrease inno-
vation effort due to subtle interactions between the investment efficiency effect and the regulatory cost effect. Second, we
demonstrate that the optimal design of GAAP standards and the entrepreneur’s incentive to violate these standards depend
critically on the relative magnitudes of the fixed and the variable regulatory penalties. The extant literature on accounting
standards, in contrast, focuses on settings in which the fixed cost of non-compliance is zero, implying that the entrepreneur
will never fully comply with the standard even when the standard is very low.3 Lastly, we demonstrate that the relative size
of the fixed and variable regulatory penalties matter, not only because they affect the optimal stringency of the standards,
but also because they determine whether standards and regulatory enforcement are expected to be positively or negatively
related when aimed at maximizing innovation and social welfare. The extant literature on standards is silent about how
standards and enforcement interact.

2. Model

We study the interaction between entrepreneurial innovation, accounting standards, and regulatory enforcement. Con-
sider an economy containing a representative entrepreneur and representative investors. The risk-neutral entrepreneur ex-
pends research and development effort searching for an innovative project.4 To implement a new project the entrepreneur
issues a report prepared under GAAP standards and solicits capital from risk-neutral investors. The entrepreneur can violate
the standards but only at the cost of potential penalties if exposed by the regulator. The game has four dates.
Date 1 – Innovation effort: At date t = 1, the entrepreneur makes an unobservable research and development effort
choice a ∈ [0, 1], which is associated with a personal cost of ga2 /2. With probability a, the entrepreneur discovers a new

3
Studies that examine financial reporting in the presence of misreporting penalties, such as Fischer and Verrecchia (20 0 0), Guttman et al. (2006), and
Fischer and Stocken (2010), also do not explore the consequence of fixed penalties. Further, unlike the focus of this study, these studies do not consider
standard setting.
4
The Organization of Economic Cooperation and Development defines innovation as including the implementation of a new or significantly improved
product, process, marketing method, or organizational practices (OECD, 2010). Innovation is a consequence of research and development activity. Research
is the “investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service”
(FASB, 1974, para. 8a). Development is the “translation of research findings or other knowledge into a plan or design for a new product or process or for a
significant improvement to an existing product or process” (FASB, 1974, para. 8b).
224 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

project and with probability (1 − a ) she fails to uncover one. Upon discovery, the entrepreneur privately observes a signal
θ ∈ [0, 1], which indicates the probability of success if the project is implemented. The signal follows a cumulative distribu-
tion function F(θ ) with positive probability density f(θ ) over the unit interval. In Section 5 and thereafter, we assume θ is
uniformly distributed. This assumption simplifies the analysis and makes the exposition more transparent.
To implement the project, the entrepreneur has to raise capital I > 0 from investors. If the entrepreneur does not discover
a new project, or discovers one but investors do not fund it, then the payoffs to all players are normalized to zero. If the
entrepreneur discovers a project and investors inject capital I, then the project generates a payoff x at date t = 4. Specifi-
cally, the project either succeeds and generates x = X > 0 with probability θ , or it fails and generates x = 0 with probability
(1 − θ ). As the entrepreneur spends costly effort to search for a new project, which has a high albeit uncertain payoff, and
enjoys a payoff only if the project is ultimately successful, we view the entrepreneur as engaging in innovation (rather than
simply capital budgeting).
Date 2 – Reporting: At date t = 2, the entrepreneur produces a publicly observable accounting report, R ∈ {RL , RH }. The
accounting report is prepared under a set of generally accepted accounting principles, which we label a GAAP standard. This
standard requires that the probability θ of successfully generating cash flow X must be sufficiently high for the entrepreneur
to release a favorable report RH . Specifically, the GAAP standard is a threshold, denoted θ P , with θ P > 0, that partitions the
signal θ so that the report is unfavorable R = RL , for all θ ∈ [0, θP ), and favorable R = RH , for all θ ∈ [θP , 1]. A standard
θP is said to be more stringent than another standard θP if and only if θP > θP . A more stringent standard also can be
interpreted as being a more conservative standard (see Kwon et al., 2001). We will initially assume that the GAAP standard
θ P is exogenous. Later, in Section 6, we shall determine the value of θ P that a standard-setter would choose to maximize
social welfare.
After privately observing the realization of θ , the entrepreneur decides whether or not to comply with the GAAP standard.
Non-compliance involves sending a high report R = RH when θ < θ P or sending a low report R = RL when θ > θ P .
As we shall establish in Section 4, when the signal equals or exceeds the GAAP standard, θ ≥ θ P , the entrepreneur will
comply with the standard and issue a favorable report RH . When the signal is below the standard, θ < θ P , the entrepreneur
may choose to misclassify the project and release RH instead of RL . If this is the case, there exists a range of values θ ∈
[θT , θP ), for which the entrepreneur misclassifies the project. We refer to the threshold θ T as the shadow threshold. The
shadow threshold and not the GAAP standard determines the report: the entrepreneur will issue a favorable report for all
θ ∈ [θT , 1] and an unfavorable report for all θ ∈ [0, θT ). The entrepreneur is said to fully comply with the standard if she
chooses θT = θP .
A regulatory agency, such as the SEC’s Division of Enforcement, investigates the firm’s report with some probability. If
the entrepreneur complied with the standard, she incurs no penalties. If the entrepreneur violated the standard (and issued
RH despite θ < θ P ), she faces financial sanctions, disbarment from serving as an officer or director, and other related costs
such as loss of reputation or the cost of hiring legal council.5 Specifically, for any realized signal θ < θ P , the entrepreneur’s
expected cost of non-compliance is given by

k(θ , θP ) = (πF + πV (θP − θ ) )K. (1)

The cost function in (1) consists of a fixed component π F and a variable component πV (θP − θ ), which is increasing in
the magnitude of the violation (θP − θ ).6 The parameter K captures the probability that the regulator investigates the firm,
which depends on the regulator’s budget, and is referred to as the intensity of regulatory enforcement.
As long as the variable component is positive, π V > 0, the standard-setter has some control over the entrepreneur’s ex-
pected costs of non-compliance. Specifically, by increasing the GAAP standard, the standard-setter increases the distance
between θ P and any θ < θ P , and thereby increases the expected regulatory penalties, k(θ , θ P ). Unless otherwise noted, we
assume that π V > 0 and π F > 0.
Date 3 – Investment decision: At date t = 3, after observing the report R, the potential investors decide whether to pro-
vide the required capital I. We assume that the unconditional net present value (NPV) of the project is zero, E [θ ]X − I = 0, to
ensure that the report has an impact on the investors’ financing decision.7 Let θT denote the shadow threshold the investors
anticipate. Thus, when the report is unfavorable, R = RL , investors believe that θ ∈ [0, θT ). In this case, given assumption
E [θ ]X − I = 0, the expected NPV is negative, and investors do not provide financing. When the report is favorable, investors
believe that θ ∈ [θT , 1], and the expected NPV is positive. Investors are then willing to provide capital I in return for a re-
payment D from the firm. The entrepreneur can repay D to investors at date t = 4 only if the project succeeds. The financial
contract can be interpreted either as a debt contract, where D is the face value of the debt, or as an equity contract, where

5
In this model, we do not consider investors’ ability to recover monetary penalties from the entrepreneur. If investors could recover damages, the
magnitude of these damages would affect the firm’s cost of capital and, in turn, the equilibrium level of manipulation. For a study that considers these
issues, see Laux and Stocken (2012).
6
Related to this cost function, the legal literature argues that litigation costs typically have a fixed component and a variable component that increases
with the level of damages (e.g., Hersch and Viscusi, 2007; Katz, 1988, and Polinsky and Shavell, 2014).
7
Our results generalize to the case in which E [θ ]X − I is mildly positive or negative. If, however, the expected NPV is extremely high, the investors
always invest in the project regardless of the report, and conversely, if the NPV is extremely low, they never invest.
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 225

investors obtain a fraction D/X of the equity. To ensure that investors break even on their investment, D must satisfy
1
θ f (θ )dθ
D(θT ) =  1 T I. (2)
θT θ f (θ )dθ

Observe that investors require a smaller level of D when the anticipated shadow threshold θT is larger.
Date 4 – Outcome: At date t = 4, the project outcome x is realized. The entrepreneur receives a payoff only if she
discovers a new project, which occurs with probability a, the report is favorable so investors finance the project, which
happens when θ ≥ θ T , and the project ultimately succeeds. The entrepreneur’s ex ante cash flow therefore is given by
 1  
a θ X − D(θT ) f (θ )dθ . (3)
θT
In a first-best environment in which the entrepreneur has sufficient funds to implement a new project without having to
raise capital from investors, the entrepreneur invests if and only if θ exceeds the first-best threshold θ FB , where θF B X − I = 0.
Consequently, her first-best innovation effort level is

1 1
aF B = ( θ X − I ) f ( θ )d θ . (4)
g θF B
We make two additional assumptions regarding the parameters of the regulatory environment:

θF B ( X − D ( θF B ) ) < k ( θF B , 1 ) (A1)
and

πF K < θF B (X − D(θF B )), (A2)

which we refer to as Assumption A1 and Assumption A2, respectively. Assumption A1 ensures that it is possible for the
standard-setter to induce the first-best threshold θT = θF B by choosing a sufficiently high GAAP standard θ P . Assumption A2
ensures that the fixed penalty for non-compliance π F K is not so high that the standard-setter can implement θT = θF B and
simultaneously induce full compliance θT = θP . If Assumption A2 does not hold, the standard-setter can trivially implement
first-best investment θ FB and first-best effort aFB by setting θP = θF B .
Before turning to the analysis, we pause to motivate two key features of our model. First, we model accounting standards
as being binary project classification rules. The presence of binary thresholds for the recognition of events is a ubiquitous
feature of extant accounting principles. As an example, consider the accounting for research and development costs. Under
ASC 730, research and development costs are expensed when incurred because future economic benefits are deemed to be
uncertain. In contrast, under IAS 38, research costs are expensed whereas development costs are recognized as an asset if a
firm can demonstrate, among other things, that the intangible asset will generate probable future economic benefits. Like-
wise, under ASC 350, the costs incurred developing internal-use software, which include coding and hardware installation,
are capitalized if, among other things, it is probable that the project will be completed and the software used as intended.
A future event is defined as being “probable” if it is “likely to occur.” The probability threshold for whether an event is
regarded as being likely to occur varies between U.S. GAAP (where it is interpreted as a 75–80% probability threshold) and
IFRS (where it is regarded as a 50% probability threshold) (PWC, 2014).
In our model, θ P reflects a summary measure of the set of conditions in a standard that must be satisfied to justify a fa-
vorable report. We view a standard as being more stringent when the conditions that need to be satisfied to issue a favorable
report are more demanding. The key feature of these and many other accounting standards is that firms face probabilistic
evidentiary thresholds for recognizing and classifying events. For further discussion of binary accounting classifications, see
Dye (2002), Chen et al. (2010), and Gao (2014).
Second, we model the entrepreneur’s expected cost of non-compliance as having a fixed component π F and a variable
component (θP − θ )πV . The primary anti-fraud provisions of the federal securities laws are Section 10(b) of the Securities
Exchange Act of 1934 and the related SEC promulgated Rule 10b-5. When the SEC brings charges of fraud under these
provisions, it must prove that defendants acted with intent (scienter), that is, the defendants knew the financial report was
misleading. The scienter standard requires the plaintiff to establish an “extreme departure from the standards of ordinary
care” (Hansen and Carr, 2014). The high burden of proof with respect to intent makes enforcing Section 10(b) and Rule
10b-5 violations difficult (Karpoff et al., 2008b). Arguably, regulatory agencies are more likely to successfully bring scienter-
based enforcement charges when a violation is more egregious.8 The notion that the expected penalties are increasing in
the magnitude of the violation (θP − θ ) is captured in the model by the variable cost component.
In addition, the SEC can and does pursue securities enforcement actions under Section 17(a)(2) of the Securities Act of
1933, which prohibits misrepresentations and omissions in the offer or sale of securities. The key difference between Rule
10b-5 and Section 17(a)(2) is that the latter does not require the SEC to prove intent, enabling the agency to aggressively

8
Karpoff et al. (2008a) find empirical evidence that monetary and non-monetary penalties (including jail sentences) are positively related to the scope
of the violation.
226 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

enforce even minor rule violations. Indeed, in recent years the SEC has increasingly relied on Section 17(a) to pursue lower-
profile cases that were historically not viewed by the agency as high-priority.9 In a speech in 2013, the former SEC Chair
Mary Jo White proclaimed, “Investors do not want someone who ignores minor violations, and waits for the big one that
brings media attention. Instead, they want someone who understands that even the smallest infractions have victims... .
And so, I believe it is important to pursue even the smallest infractions.” Chair White continues, “As I have said, we are
casting our nets wider, and using nets with smaller spaces, paying attention to violations and violators regardless of size.
We are able to do this by streamlining our investigations, particularly those involving strict liability violations where we do
not need to prove intent... .” (White, 2013). The SEC lived up to its promise and brought a record number of enforcement
actions against individuals even for relatively minor infringements. Eaglesham (2016) reports that the SEC has filed 868
cases for the 12 months through September 2016, the most cases in its history. He further notes, “While case numbers are
strongly up... sanctions appear flat, suggesting an increased emphasis on smaller cases.” The SEC’s pursuit of all types of
violations, regardless of their size, is captured in our model by the fixed cost component π F , which does not vary with the
size of the offense.

3. Benchmark

Consider a setting in which there is no standard-setter but the entrepreneur can commit in advance to fully comply with
a specific classification threshold θ T . While it is naive to suppose that firms eschew misreporting in light of the evidence
suggesting strategic earnings manipulation (e.g., Burgstahler and Dichev, 1997), this setting will serve as a useful benchmark
when we later explore how accounting standards affect entrepreneurial innovation. In this benchmark, the entrepreneur can
achieve the first-best outcome even though she has to raise capital I from investors. Since investors break even on their
investment in equilibrium, the entrepreneur’s ex ante utility is given by
 1
ga2
UE = a ( θ X − I ) f ( θ )d θ − . (5)
θT 2
The entrepreneur’s optimal threshold θ T and effort a are then given by

1 1
θT = θF B = I/X and a = aF B = ( θ X − I ) f ( θ )d θ . (6)
g θF B
When the entrepreneur can commit to a specific reporting threshold θ T , she optimally chooses the threshold that im-
plements the first-best investment level, θT = θF B . Since investors break-even, it is the entrepreneur who benefits from the
commitment to invest efficiently. Setting θT = θF B maximizes the entrepreneur’s ex ante value of discovering a new project
and, in turn, encourages first-best innovation effort. As we shall show next, these results no longer hold if the entrepreneur
privately chooses the threshold θ T .

4. Reporting

Consider the entrepreneur’s optimal reporting strategy after she discovers a new project. If the signal θ lies in the range
[θ P , 1], the GAAP standard calls for a favorable report RH . The entrepreneur then complies with the standard, and investors
provide financing. The entrepreneur has no reason to misreport because she always prefers project implementation that
yields an expected payoff of θ (X − D(θT )) over project termination that leaves her with zero payoffs.
In contrast, when the signal θ lies in the range [0, θ P ), the GAAP standard calls for an unfavorable report RL . Compliance
with the standard then prevents the entrepreneur from raising capital, and leaves her empty handed. The entrepreneur
violates the standard and issues RH if the expected payoff from investment is at least as large as the expected regulatory
penalties, that is, if
θ (X − D(θT )) ≥ (πF + πV (θP − θ ))K, (7)
and complies with the standard and issues RL otherwise.
For higher values of θ , the entrepreneur’s expected payoff from investment is larger and the penalty for non-compliance
is smaller; that is, the left hand side of (7) is strictly increasing in θ , whereas the right hand side is strictly decreasing in θ .
Hence, there is a unique shadow threshold, θ T , with θ T ≤ θ P , such that the entrepreneur issues a favorable report, R = RH , if
θ ≥ θ T and an unfavorable report, R = RL , if θ < θ T .
Since the entrepreneur’s objective function is common knowledge, in equilibrium the investors correctly anticipate the
entrepreneur’s choice of the shadow threshold; that is, θT = θT . The next proposition establishes the entrepreneur’s equi-
librium reporting strategy. There is a unique threshold θ P , which we refer to as the full-compliance threshold, such that the
entrepreneur fully complies with the GAAP standard and chooses θT = θP when θ P ≤ θ P , and does not fully comply and
chooses θ T < θ P when θ P > θ P .

Proposition 1. Let θ P denote the GAAP standard that satisfies

θ P (X − D(θ P )) = πF K . (8)

9
See Goel et al. (2012), Hansen and Carr (2014), Eaglesham and Fuller (2015), and Eaglesham (2016).
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 227

(i) If θ P ≤ θ P , the equilibrium shadow threshold is θT = θP , and the entrepreneur fully complies with the standard.
(ii) If θ P > θ P , the equilibrium shadow threshold, θ T , is the unique solution to
θT (X − D(θT )) = (πF + (θP − θT )πV )K , (9)
and satisfies θ P < θ T < θ P . The entrepreneur then misclassifies the project for all θ ∈ [θT , θP ).
Proofs are relegated to the Appendix. When the fixed cost of non-compliance is positive, π F > 0, the entrepreneur expects
regulatory penalties for even small deviations from the GAAP standard. Part (i) of Proposition 1 shows that the entrepreneur
will fully comply with the standard θ P as long as the standard is relatively lenient, that is, as long as θ P ≤ θ P . For θ P ≤ θ P
the entrepreneur complies and chooses θT = θP not only because violations from the standard can trigger penalties, but also
because for small realizations of θ the project is unlikely to succeed anyway. Assumption A2 implies that the full-compliance
threshold θ P lies below the first-best threshold, θ P < θ FB . We focus on this case because if θ P ≥ θ FB , the standard-setter can
trivially implement the first-best outcome simply by setting θP = θF B .
As the fixed cost π F declines, the full-compliance threshold θ P declines as well. Intuitively, for a smaller π F , deviating
from the standard is less costly, and the entrepreneur will only continue to comply if the standard becomes more lenient. In
the extreme, when πF = 0, we obtain θ P = 0. In this case, there is no standard θ P > 0 that ensures full compliance, similar
to the extant literature that considers only variable non-compliance costs (e.g., Dye, 2002).
Part (ii) of Proposition 1 shows that when the GAAP standard θ P exceeds θ P , the entrepreneur no longer fully complies.
Instead, she chooses a shadow threshold that lies below the GAAP standard, θ T < θ P , and misclassifies the project for all
θ ∈ [ θT , θP ) .
The next proposition shows how changes in the GAAP standard affect the entrepreneur’s reporting strategy.

Proposition 2
(i) If θ P < θ P , an increase in θ P increases θ T by the same amount, that is dθT /dθP = 1, and the entrepreneur continues to fully
comply with the GAAP standard and chooses θT = θP .
(ii) If θ P ≥ θ P , an increase in θ P increases θ T but by a smaller amount, that is, dθ T /dθ P ∈ (0, 1), and hence increases the misclas-
sification range (θ T , θ P ).
When the GAAP standard lies below the full-compliance threshold, θ P < θ P , Proposition 1 established that the en-
trepreneur always complies and chooses θT = θP . Accordingly, an increase in θ P leads to an identical increase in θ T .
In contrast, when the GAAP standard exceeds the full-compliance threshold, θ P > θ P , then θ T < θ P , and the entrepreneur
violates the standard for all θ ∈ [θT , θP ). In this case, an increase in θ P causes θ T to increase, but by a smaller amount,
dθ T /dθ P ∈ (0, 1). As a consequence, stricter GAAP standards widen the non-compliance region [θ T , θ P ). The intuition for this
result is as follows. Given that the expected cost of non-compliance is increasing in the magnitude of the violation (θP − θ ),
an increase in θ P reduces the entrepreneur’s temptation to misclassify the project, and induces a higher shadow threshold
θ T . However, there is a second effect that works in the opposite direction. As θ T increases, the entrepreneur’s expected
payoff from investment θT (X − D(θT )) increases because the likelihood of project success is higher and because investors
are willing to provide the required capital I in exchange for a smaller repayment D, leaving the entrepreneur with a higher
residual payoff. The higher expected payoff from investing strengthens the entrepreneur’s incentive to misclassify the project
to obtain financing. This effect dampens the positive effect of θ P on θ T , yielding dθ T /dθ P < 1.

5. Entrepreneurial innovation

We are interested in the question of how a change in the GAAP standard θ P affects the entrepreneur’s incentive to
expend innovation effort a. To keep the analysis tractable, we assume in what follows that θ is uniformly distributed on
the unit interval. The entrepreneur’s ex ante utility is obtained by substituting D(θ T ) from (2) into (3), where θT = θT , and
taking into account the expected costs of non-compliance and innovation effort:
 1  θP 
ga2
UE = a ( θ X − I ) f ( θ )d θ − (πF + (θP − θ )πV )K f (θ )dθ − . (10)
θT θT 2
The entrepreneur’s optimal choice of innovation effort is therefore
a∗ = V/g, (11)
where
 1  θP
V ≡ ( θ X − I ) f ( θ )d θ − (πF + (θP − θ )πV )K f (θ )dθ
θT θT
denotes the entrepreneur’s expected payoff from discovering a new project.
Condition (11) shows that a∗ is an inverted U-shaped function of the GAAP standard θ P . Specifically, there is a unique
interior threshold, denoted θPI , such that innovation effort increases with the GAAP standard for all θP < θPI and decreases
for all θP > θPI . This observation is formally stated in the next proposition.

Proposition 3. There exists a unique GAAP standard, denoted θPI , such that:
228 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

(i) innovation effort a∗ increases with θ P if θP < θPI , and

(ii) innovation effort a∗ decreases with θ P if θP > θPI .

An increase in the GAAP standard θ P has two effects on the entrepreneur’s expected payoff V from discovering a new
project and, in turn, on her choice of innovation effort. The first effect, which we term the investment efficiency effect, arises
because the GAAP standard affects the usefulness of the accounting report for making investment decisions. Suppose the
GAAP standard induces the entrepreneur to choose a shadow threshold that lies below the first-best level, θ T < θ FB , which
results in overinvestment for all θ ∈ (θ T , θ FB ). When the GAAP standard θ P rises, the threat of higher penalties induces the
entrepreneur to increase the shadow threshold θ T , causing the overinvestment range (θ T , θ FB ) to shrink. The increased in-
vestment efficiency benefits the entrepreneur because it allows her to obtain the required capital for a lower repayment D.
As a consequence, the entrepreneur enjoys a higher expected payoff V from uncovering a new project, and she becomes
more eager to render innovation effort. The innovation effort increases with the GAAP standard θ P until the shadow thresh-
old reaches the first-best level θT = θF B . At this point, any further increase in θ P pushes the shadow threshold above first-
best, θ T > θ FB , leading to underinvestment for all θ ∈ (θ FB , θ T ). The reduced investment efficiency then lowers the project’s
expected payoff V and hence the entrepreneur’s incentive to discover new projects.
The second effect, which we term the regulatory cost effect, arises when the entrepreneur does not fully comply with the
GAAP standard. When the GAAP standard lies above the full-compliance threshold, θ P > θ P , the entrepreneur misclassifies
the project for all θ ∈ [θT , θP ). From an ex ante perspective, the entrepreneur therefore incurs an expected regulatory penalty
θ
of θ P (πF + πV (θP − θ ) )Kdθ if she uncovers a new project. We know from Proposition 2 that raising the GAAP standard will
T
increase the misclassification region [θ T , θ P ) because θ T increases less quickly than θ P . The wider misclassification region
[θ T , θ P ) increases the expected regulatory penalties and thus reduces the expected payoff V from uncovering a new project.
Consequently, the entrepreneur’s incentive to expend innovation effort declines as the GAAP standard increases.
An immediate implication of these effects is that the innovation maximizing standard θPI must lie in the range θPI ∈
[θ P , θ P ), where θ P denotes the GAAP standard that induces first-best investment, θT = θF B . To see why θPI ∈ [θ P , θ P ), suppose
first that θ P < θ P . The entrepreneur will then fully comply with the standard, θT = θP , and the regulatory cost effect is mute.
The only effect at work is the investment efficiency effect: as the GAAP standard θ P increases, the entrepreneur’s choice of
θ T moves closer to θ FB , which increases the ex ante value V of uncovering a new project and the entrepreneur’s incentive
to innovate. Thus, the GAAP standard that maximizes innovation effort cannot lie below θ P . Suppose now that θP = θ P . The
entrepreneur then chooses the first-best threshold, θT = θF B . A further increase in the GAAP standard not only increases the
misclassification region [θ T , θ P ), but also pushes the shadow threshold above the first-best level, leading to underinvestment,
θ T > θ FB . Both effects suppress the entrepreneur’s incentive to search for new projects, implying that θPI cannot lie above θ P .
We can also rule out θPI = θ P because for θP = θ P , a marginal reduction in θ P has a negligible effect on the investment
efficiency but mitigates regulatory penalties, and hence increases innovation. The next proposition formalizes this result.

Proposition 4. The innovation maximizing standard θPI lies in the range θPI ∈ [θ P , θ P ), and induces the entrepreneur to choose
θT ∈ [ θ P , θF B ) .
Proposition
 4 indicates that the effect of an increase in the GAAP standard θ P on innovation effort is ambiguous only for
θP ∈ θ P , θ P . An increase in θ P is then a double-edged sword: On one hand, more stringent standards improve investment
efficiency, which increases the entrepreneur’s expected payoff V from the project and hence her incentive to innovate. On
the other hand, stricter standards lead to higher regulatory penalties for the entrepreneur, which reduces the expected
payoff V and thus her incentive to innovate.
The next proposition characterizes the properties of the innovation maximizing standard, θPI . It shows that θPI either
equals the full-compliance threshold, θ P , or exceeds it, depending on the relative mix of the variable and fixed penalties.

Proposition 5. Let (π
F , π
V ) denote any parameter constellation that solves da∗ /dθP = 0 when evaluated at θP = θ P . The GAAP
standard that maximizes innovation effort, θPI , is characterized by:

(i) θPI = θ P if the regulatory penalties are mainly fixed, that is, πF ≥ π
F and πV ≤ π V ,
(ii) θPI > θ P and da∗ /dθP = 0 if the regulatory penalties are mainly variable, that is, πF ≤ π
F and πV ≥ π
V , where at least one of
the inequalities is strict.

To provide intuition for these results, consider the effect of a change in θ P on innovation effort, which is given by
⎛ ⎞
⎜  ⎟
da∗ ⎜ d θT d θT ⎟
=⎜ − ( θT X − I ) −K (πF + (θP − θT )πV ) 1 − ⎟/g, (12)
d θP ⎝ d θP d θP ⎠
   
Investment efficiency effect Regulatory cost effect

where
d θT K πV
=   ∈ (0, 1 ).
d θP
K πV + X 1 − 1
(θT +1 )2
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 229

The strengths of the investment efficiency and regulatory cost effects depend on the relative magnitudes of the fixed
and variable regulatory penalties. Suppose first the expected cost of non-compliance is mainly fixed, that is, π F is high
and π V is low. Raising the GAAP standard θ P above θ P increases the shadow threshold θ T and induces non-compliance.
Since the variable cost π V is small, the increase in θ T is also small. Thus, dθ T /dθ P is small and the investment efficiency
gain associated with an increase in θ P is weak. However, since the fixed cost π F is relatively large, the entrepreneur’s cost
of misclassifying the project is also relatively high even for small deviations. As a consequence, the regulatory cost effect
dominates the investment efficiency effect. Setting a GAAP standard above θ P , therefore, would weaken the entrepreneur’s
incentive to expend innovation effort; formally, da∗ /dθ P < 0 when θ P ≥ θ P . It follows that the GAAP standard that maximizes
innovation is the one that ensures full compliance θPI = θ P , which explains Proposition 5(i).
Conversely, suppose the expected regulatory penalties are mainly variable, that is, π F is low and π V is high. As before,
choosing a standard θ P above θ P pushes the shadow threshold closer to first-best and induces non-compliance. But here the
increase in the threshold θ T is more pronounced since π V is high. Consequently, dθ T /dθ P is large and the investment effi-
ciency effect is strong. In addition, the regulatory cost effect is weak as small deviations from the standard lead to relatively
small expected penalties. As a result, for θP = θ P , the investment efficiency effect dominates the regulatory cost effect, and
increasing θ P above the full-compliance threshold θ P heightens the entrepreneur’s incentive to innovate. This observation
explains why the standard that maximizes innovation effort lies above the full-compliance standard θ P in Proposition 5(ii).
As the GAAP standard θ P further increases, the shadow threshold θ T moves closer to the first-best level θ FB . Consequently,
the investment efficiency effect weakens, as −(θT X − I ) becomes smaller in (12), and the regulatory cost effect strengthens,
as K (πF + (θP − θT )πV ) becomes larger in (12).10 Indeed, when θ P is so large that θ T converges to θ FB , the investment
efficiency effect vanishes while the regulatory cost effect remains. The unique standard θPI that maximizes innovation effort
trades off the investment efficiency effect against the regulatory cost effect, resulting in da∗ /dθP = 0 in (12). Due to this
trade-off, the innovation maximizing standard θPI induces a shadow threshold below the first-best level θ T < θ FB , which
also explains why θPI < θ P in Proposition 4. Intuitively, although a further increase in θ P would push θ T closer to θ FB , the
resultant greater investment efficiency is more than offset by greater regulatory penalties. In sum, the analysis shows that
when the expected regulatory costs are mainly variable, the standard that maximizes innovation leads to both a positive
range of noncompliance (θT , θPI ) and a positive range of overinvestment (θ T , θ FB ).

6. Optimal standards

We now consider a standard-setter who chooses the GAAP standard that maximizes social welfare, which is the aggregate
utility of the entrepreneur and investors. Since investors break even in expectation, social welfare equals the entrepreneur’s
utility, UE , given in (10). Substituting the optimal level of innovation effort a∗ from (11) into (10) yields

UE = a∗2 g/2,

which shows that the standard-setter maximizes social welfare by choosing the standard that induces the highest possible
innovation effort.

Proposition 6. The standard-setter’s optimal GAAP standard, denoted θP∗ , induces the highest level of innovation effort, θP∗ = θPI .

As an aside, recognizing that the value of regulatory intervention can lie in forcing firms to consider negative or positive
externalities associated with their decisions, it is straightforward to introduce an additional conflict of interest between the
entrepreneur and the society. We can assume that the project creates costs or benefits to the society that neither the firm
nor its investors take into consideration but that the standard-setter recognizes. Adding such costs or benefits, provided they
are not too large, does not qualitatively affect our results.
To gain further insight into how non-compliance and the associated regulatory costs affect innovation, we compare the
entrepreneur’s investment decision and innovation effort with the first-best levels. The optimal GAAP standard is character-
ized by either θP∗ = θ P or θP∗ > θ P , as established in Proposition 5.
When θP∗ = θ P , the entrepreneur fully complies with the standard θT = θP , resulting in no regulatory penalties. However,
the full-compliance standard θ P induces a shadow threshold below first-best, θT = θ P < θF B , which causes overinvestment
for all θ ∈ [θT , θF B ). Investors anticipate the overinvestment and protect themselves by demanding a higher D, leaving the
entrepreneur with a lower expected payoff V from discovering a project. The entrepreneur is then less eager to expend
innovation effort, which results in a∗ < aFB .
When θP∗ > θ P , the optimal standard trades off the investment efficiency effect against the regulatory cost effect. This
trade-off yields both non-compliance for all project quality realizations θ ∈ [θT , θP ) and overinvestment for all θ ∈ [θT , θF B ).
Non-compliance costs as well as inefficient investment reduce the entrepreneur’s payoff V from uncovering a new project
and hence her incentive to expend innovation effort, a∗ < aFB .
Thus, irrespective of the relative magnitudes of the fixed and the variable regulatory costs, the entrepreneur’s ability to
misreport dampens innovation effort and leads to overinvestment. This observation is formalized in the next corollary.

10
Recall that the difference between θ P and θ T increases as θ P increases.
230 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

Corollary 1. Under the optimal standard, θP = θP∗ , the entrepreneur chooses an innovation effort below the first-best level,
a∗ < aFB , and overinvests in the project relative to the first-best level, θ T < θ FB .

7. Interaction between standards and enforcement

Optimal accounting standards facilitate entrepreneurial activity. Importantly, standards must be accompanied by the ap-
propriate level of regulatory enforcement. Indeed, the adoption of IFRS in the European Union, perhaps the largest financial
reporting change in history, was accompanied by a series of regulatory directives. Beginning with the Financial Services Ac-
tion Plan in 1999, the European Union passed several directives, including the Transparency Directive requiring countries to
create or designate an enforcement agency that reviews firm disclosure and the Prospectus Directive regulating disclosure
during public security offerings; see Christensen et al. (2013) for more details.
A goal of this paper is to characterize how the optimal GAAP standard θP∗ varies with changes in the intensity of regula-
tory enforcement, represented by the parameter K. The next proposition establishes the relation between θP∗ and K.

Proposition 7. Accounting standards and regulatory enforcement interact to determine entrepreneurial activity and social welfare
as follows:

(i) If regulatory penalties are mainly fixed, that is, πF ≥ π

F and πV ≤ π
V , the optimal GAAP standard θP∗ increases in the enforce-
ment intensity K.
(ii) If regulatory penalties are mainly variable, that is, πF ≤ π
F and πV ≥ πV , where at least one of the inequalities is strict, the
optimal GAAP standard θP∗ decreases in the enforcement intensity K.

The interaction between optimal accounting standards and regulatory enforcement intensity depends on whether the
costs of non-compliance are mainly fixed or variable. Suppose first that the expected regulatory penalties are mainly fixed,
that is, π F is large relative to π V . In this case, the optimal standard equals the full-compliance threshold, θP∗ = θ P = θT , as
established in Proposition 5(i). An increase in the enforcement intensity K heightens the regulatory cost associated with
non-compliance and raises the full-compliance threshold θ P . However, since the entrepreneur already fully complies with
the standard θ P , an increase in K has no effect on the entrepreneur’s behavior, unless θ P increases as well. Thus, to take
advantage of the greater enforcement, the standard-setter has to react by setting a more stringent standard. The standard-
setter will optimally raise the standard until it once again attains the full-compliance threshold, θP = θ P . The increase in
θ P moves the shadow threshold θ T closer to the first-best level, without creating incentives for non-compliance, thereby
encouraging higher innovation effort—the investment efficiency effect is at work here. As a result, optimal GAAP standards
and enforcement intensity are positively related, which explains Proposition 7(i).
Suppose now that the expected cost of non-compliance is mainly variable, that is, π V is large relative to π F . In this
case, we know from Proposition 5(ii) that the optimal GAAP standard exceeds the full-compliance threshold, θP∗ > θ P . Since
the entrepreneur does not fully comply with the standard, θ T < θ P , an increase in enforcement intensity K changes the
entrepreneur’s reporting behavior, even when the standard θ P remains unchanged. Specifically, stricter enforcement encour-
ages the entrepreneur to choose a shadow threshold θ T closer to the GAAP standard θ P and hence closer to the first-best
level θ FB . Since the shadow threshold θ T is now closer to first-best, the investment efficiency effect gets weaker: formally,
−(θT X − I ) becomes smaller in (12). Consequently, the regulatory cost effect now dominates the investment efficiency effect.
In response, the standard-setter lowers the GAAP standard θ P to reduce the expected regulatory penalties, which strengthens
the entrepreneur’s incentive to innovate. The standard-setter continues reducing θ P until the balance between the regulatory
cost effect and the investment efficiency effect is once again restored; that is, until da∗ /dθP = 0 in (12). As a result, optimal
GAAP standards and enforcement intensity are negatively related, which explains Proposition 7(ii).
The analysis highlights that changes in enforcement intensity K call for standard-setters to revise standards, but to do so
in a subtle manner. On one hand, when the expected regulatory penalties are mainly fixed, a standard-setter must tighten
GAAP standards in response to an increase in enforcement intensity to have a positive impact on innovation and social
welfare. On the other hand, when the expected regulatory penalties are mainly variable, an increase in enforcement intensity
increases the entrepreneur’s shadow threshold and the optimal response of the standard-setter is to weaken GAAP standards.

8. Discussion

Empirical research on the relation between accounting standards and innovation is scarce. Chang et al. (2015) posit and
find that firms with more conservative financial reports are less likely to engage in innovative activities, as manifested in the
number of patent grants and patent citations. Accounting conservatism requires the immediate recognition of losses when
they are probable but delays the recognition of gains until they are realized, and thereby increases the probability of low
reports. In our setting, raising the GAAP standard increases the probability of an unfavorable classification and hence can be
viewed as imposing more conservative accounting practices. In contrast to the negative relation that Chang et al. (2015) doc-
ument, we predict that choosing stricter GAAP standards has an inverted U-shaped functional relation with innovation effort.
Our analysis suggests that the power of the tests in Chang et al. (2015) might be enhanced if their sample was partitioned
based on the level of conservatism.
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 231

Christensen et al. (2013) argue that identifying the effect of changing accounting standards is confounded by changes to
the regulatory environment. Consequently, in their study of the capital market effects of adopting IFRS, they separate the
effects of changes in enforcement from changes in the accounting standards. Among their findings, they establish that the
liquidity benefits from adopting IFRS are muted when not accompanied by improvements in the enforcement environment.
Moreover, they document a liquidity benefit for firms facing heightened enforcement despite not adopting IFRS. They con-
clude that changes in enforcement are the primary determinant of the capital market benefits associated with the adoption
of accounting standards. In their discussion of this work, Barth and Israeli (2013) argue that strong enforcement and stricter
standards both yield liquidity benefits. Our analysis highlights that standards and regulatory enforcement interact in a sub-
tle fashion: optimal standards and regulatory enforcement can be positively or negatively related depending on whether the
regulatory penalties are predominantly fixed or variable.
An implication of our model is that the behavior of a country’s standard-setters and regulators requires careful coordi-
nation.11 Standards ought to be customized at the national level in accordance with the specific regulatory environment to
maximize a country’s innovation activity and social welfare. Our analysis also contributes to the debate about harmonizing
cross-country financial reporting to ensure a high degree of comparability.12 The difference in the enforceability of stan-
dards across countries hints at the difficulty of converging U.S. GAAP and IFRS. With countries having different regulatory
enforcement environments, standards aimed at maximizing innovation activity and social welfare are also expected to vary
across countries.

9. Conclusion

We study the impact of accounting standards and regulatory enforcement on entrepreneurial innovation and social wel-
fare. We show that more stringent GAAP standards can have positive and negative effects on an entrepreneur’s incentive
to innovate. The positive effect arises because stricter standards reduce incentives for overinvestment, which allows the en-
trepreneur to raise capital at a lower cost and hence increases the ex ante value of discovering new projects. The negative
effect arises because more stringent standards induce the entrepreneur to violate the standards more often when seeking
financing, which increases the expected regulatory penalties and lowers the ex ante value of discovering new projects.
We find that when the expected regulatory penalties for non-compliance are relatively insensitive to the magnitude
of the violation, the standard that maximizes innovation and social welfare is the one that is sufficiently low to induce
full compliance. Imposing stricter standards is counterproductive because the associated increase in regulatory penalties
outweighs the improved investment efficiency. However, when the enforcement intensity increases (i.e., the probability of
regulatory investigation), the standard-setter can set a stricter standard and still maintain compliance, which improves in-
vestment efficiency and spurs innovation. Thus, when regulatory penalties are mainly fixed, we predict that standard-setters
will choose more stringent standards when enforcement intensity is greater.
In contrast, in environments in which the regulatory penalties are relatively sensitive to the magnitude of the violation,
the optimal accounting standard no longer induces full compliance. Raising the standard above the full-compliance threshold
is optimal because the investment efficiency effect initially dominates the regulatory cost effect. As the GAAP standard
becomes more stringent, however, the investment efficiency effect weakens and the regulatory cost effect strengthens. The
optimal standard balances these two effects, and induces both non-compliance and overinvestment. In this environment,
when there is an increase in enforcement intensity, the standard-setter responds by choosing a weaker standard, which
reduces the entrepreneur’s expected regulatory penalties and fosters innovation. Thus, when penalties are mainly variable,
we predict that standard-setters will choose less stringent standards when enforcement intensity is greater.
Our analysis suggests that to optimize innovation and social welfare, standard-setters and regulatory agencies ought to
carefully coordinate their actions. This observation is consistent with the close partnership that exists between the FASB
and the SEC (see Zeff, 1995). It also hints at the problems national accounting policy-makers face when adopting a set of
accounting standards that are not sufficiently responsive to the particular features of their countries’ regulatory and legal
environment.

Appendix

This Appendix contains the proofs of the propositions.

Proof of Proposition 1. Suppose investors conjecture that the entrepreneur chooses a shadow threshold of θT ∈ [0, 1 ). In-
vestors then demand a repayment of
1
θT f (θ )dθ
D(θ ) =
T 1 I,
θT θ f ( θ )d θ

11
See Zeff (1995) for an extensive discussion of the relationship between the SEC and the various private-sector standard-setters.
12
For a survey of this discussion, see Barth (2006) and Leuz and Wysocki (2008).
232 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

where
1  

dD(θT )  θT θ − θT f (θ )dθ
= − f ( θT )  2 I < 0.
dθT 1
θT θ f ( θ ) d θ

Since we assume E [θ ]X = I, if θT = 0, we obtain D(0 ) = X, and if θT > 0 we obtain D(θT ) < X.
We already established in the main text that the entrepreneur complies with the standard and sends a favorable report
RH if θ ∈ [θP , 1]. Suppose therefore in what follows that θ ∈ [0, θP ). The entrepreneur violates the standard and sends a
favorable report RH if the expected payoff from investment exceeds or equals the expected regulatory penalties; that is, if

(θ ) = θ (X − D(θT )) − (πF + (θP − θ )πV )K ≥ 0,

and complies with the standard and sends RL if  (θ ) < 0. If  (θ ) < 0 for all θ < θ P , the entrepreneur always complies and
the shadow threshold equals the GAAP standard, θT = θP . Since  (θ ) is increasing in θ , we obtain  (θ ) < 0 for all θ < θ P if

 ≡ θP (X − D(θT )) − πF K ≤ 0. (13)

Thus, given the investors’ conjecture θT , the entrepreneur fully complies with the standard and chooses θT = θP if
(13) holds.
Otherwise, if

 = θP (X − D(θT )) − πF K > 0, (14)

the entrepreneur’s choice of the shadow threshold θ T lies below θ P and solves

(θT ) = θT (X − D(θT )) − (πF + (θP − θT )πV )K = 0. (15)

To see that θ T is unique and lies in the range (0, θ P ), note that  (θ ) is increasing in θ , and that  (0) < 0 and (θP ) =
θP (X − D(θT )) − πF K > 0, which is positive given (14). Thus, given the investors’ conjecture θT , there is a unique threshold
θ T such that the entrepreneur violates the standard and issues RH for all θ ∈ [θT , θP ) and complies with the standard and
issues RL for all θ ∈ [0, θT ).
In equilibrium, investors correctly anticipate the entrepreneur’s choice of θ T ; that is, θT = θT . When investors anticipate
full compliance, the entrepreneur will indeed comply with the standard and choose θT = θP if

E (θP ) ≡ θP (X − D(θP )) − πF K ≤ 0.
This condition is obtained by substituting θT = θT = θP into (13). Observe that E (θ P ) is increasing in the standard θ P ,

dE (θP ) dD(θP )

= (X − D(θP )) − θP > 0,
d θP d θP
where dD(θ P )/dθ P < 0. The highest possible standard that ensures full compliance, denoted θ P , satisfies

E (θ P ) = θ P (X − D(θ P )) − πF K = 0. (16)

To see that θ P ∈ (0, θ FB ), observe that for θP = 0, we obtain = −πF K < 0, and for θP = θF B , we obtain
E ( 0 ) E (θ
FB) =
θF B (X − D(θF B )) − πF K > 0, which is positive given Assumption A2. Thus, for θ P ≤ θ P , the entrepreneur fully complies with
the standard and chooses θT = θP , which proves part (i) of the proposition.
Suppose now θ P > θ P . The entrepreneur then deviates from the standard and chooses θ T < θ P . Substituting θT = θT into
(15) yields the equilibrium choice of θ T :

 E ≡ θT (X − D(θT )) − (πF + (θP − θT )πV )K = 0. (17)

To show that the equilibrium shadow threshold θ T that solves  E = 0 is unique and lies in the range (θ P , θ P ), we make
three observations: First, for θT = θ P , we obtain  E = θ P (X − D(θ P )) − (πF + (θP − θ P )πV )K < 0, which is negative because
θ P is defined by (16). Second, for θT = θP , we obtain  E = θP (X − D(θP )) − πF K > 0, which is positive because θ P > θ P and
θP (X − D(θP )) is increasing in θ P . Third,  E is increasing in θ T ,
∂ E dD(θT )
= (X − D(θT )) − θT + πV K > 0,
∂θT d θT
with dD(θ T )/dθ T < 0. These arguments establish part (ii) of the proposition. 

Proof of Proposition 2. Consider part (i). If θ P < θ P , it follows from Proposition 1 that the entrepreneur chooses θT = θP .
Consequently, if θ P changes, then θ T changes equally, dθT /dθP = 1.
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 233

Consider part (ii). When θ P ≥ θ P , the entrepreneur chooses the shadow threshold that solves (17). Applying the implicit
function theorem to (17) yields
∂ E
d θT ∂θ K πV
= − ∂ PE = ∈ ( 0, 1 ),
d θP K πV + (X − D(θT )) − θT dDd(θθT )
∂θT T

because (X − D(θT ) ) > 0 and dD(θ T )/dθ T < 0 as established in the proof of Proposition 1.
In the case in which f(θ ) is the uniform probability density function, which we consider in subsequent propositions, we
obtain the expression
d θT K πV
=
d θP K πV + X − Dθ (θ+1
T)
T

K πV
= ∈ ( 0, 1 ), (18)
K πV + X − 2I
(θT +1 )2
−2
where E [θ ]X − I = 0 implies X − 2I (θT + 1 ) > 0. 

Proof of Propositions 3 and 5. Suppose θ P < θ P . From Proposition 1 we know that θP = θT , which simplifies the innovation
1
effort in (11) to a∗ = θ (θ X − I )dθ /g. Since θ P < θ FB (from Assumption A2), where θ FB satisfies (θF B X − I ) = 0, and θT =
T
θP < θ P , it follows that (θT X − I ) < 0. Given dθT /dθP = 1, the first derivative of a∗ with respect to θ P is positive:
da∗ d θT
= − ( θT X − I ) /g > 0.
d θP d θP
Consequently, the entrepreneur’s innovation effort a∗ increases with θ P provided θ P is below the full-compliance threshold
θ P.
Suppose now θ P ≥ θ P . Taking the first derivative of (11) gives
⎛ ⎞
⎜  ⎟
da∗ ⎜ d θT d θT ⎟
=H≡⎜ − ( θT X − I ) −K (πF + (θP − θT )πV ) 1 − ⎟/g. (19)
d θP ⎝ d θP d θP ⎠
   
Investment efficiency effect Regulatory cost effect

The first term in (19) is the investment efficiency effect. This term is positive for all θ T < θ FB since dθ T /dθ P ∈ (0, 1). The
second term in (19) is the regulatory cost effect, which is negative because dθ T /dθ P ∈ (0, 1) and θ P ≥ θ T .
We next determine the GAAP standard θPI that maximizes innovation effort. When θP = θ P , then θT = θP and condition
(19) simplifies to
  
da∗ d θT d θT
| =Y ≡ − ( θT X − I ) − K πF 1 − /g. (20)
d θ P θP = θ P d θP d θP
When Y < 0, an increase in θ P above θ P reduces innovation effort and the standard that maximizes effort is the one that
induces full compliance θPI = θ P . Alternatively, when Y > 0, an increase in θ P above θ P increases innovation effort. The stan-
dard that maximizes innovation θPI then balances the investment efficiency effect with the regulatory cost effect. Specifically,
the unique standard θPI is found by setting (19) equal to zero, H = 0, because a∗ in (11) is strictly concave in θ P .
To establish that a∗ is concave in θ P , observe that
d 2 a∗ dH (θP , θT ) ∂ H ( θP , θT ) ∂ H ( θP , θT ) d θT
= = + .
dθP2 d θP ∂θP ∂θT d θP
Using (19) we obtain
 
∂ H ( θP , θT ) d θT
= −K πV 1 − /g < 0, (21)
∂θP d θP
which is negative since dθ T /dθ P ∈ (0, 1). Further, using (18) and (19), we obtain
∂ H ( θP , θT ) 2I d θT (θT X − I ) − K (πF + (θP − θT )πV ) d2 θT
=− − < 0, (22)
∂θT g ( θT + 1 ) d θP
2 g d θP d θT
which is negative because the optimality condition da∗ /dθP = H = 0 implies that (θT X − I ) < 0 and because
∂ 2 θT 4I (θT + 1 )K πV
= − 2 < 0.
∂ θP ∂ θT (X + K π )(θ + 1 )2 − 2I
V T

Thus, d2 a∗ /dθP2 < 0, which establishes concavity.

234 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236

Note that since in the optimal solution H = 0 and dθ T /dθ P ∈ (0, 1), the equilibrium shadow threshold is characterized by
θT X − I < 0, which implies that θ T < θ FB . By Assumption A1, the highest possible standard θP = 1 induces θ T ≥ θ FB . Hence,
the standard θ P that induces θ T < θ FB is interior with θ P < 1.
Observe that Y can be written as
1   
− θP πV − 1 − 1
πF
2 (θ P +1 )2
Y = 2I K    ,
g K πV + 2I 1 − 1
(θ P +1 )2

where we recognize: (i) E [θ ]X − I = 0 implies X = 2I for the uniform distribution, (ii) θT = θP when θP = θ P , and (iii) dθ T /dθ P
is determined by condition (18). The sign of Y therefore depends on the sign of
1   
1
(πF , πV ) = − θP πV − 1 − πF , (23)
2 (θ P + 1 )2
where (1/2 − θ P ) > 0 since θ P < θ FB by Assumption A2 and θF B = 1/2.
To determine when Y is positive or negative, define (π F ,π
V ) to be such that (π
F , π
V ) = 0. Observe that there are an
infinitely many (πF , π
V ) combinations that satisfy (π
F , π
V ) = 0 as well as Assumptions A1 and A2. When θ is distributed
uniformly, and using θF B = 1/2 and X = 2I, Assumption A1 can be written as

I < 3(πF + πV /2 )K, (24)

and Assumption A2 can be written as

3πF K < I. (25)

Taking π
F > 0 as given, π
V is determined by
 
π
F 1
π
V = 1− > 0,
( 1/2 − θ P ) (θ P + 1 )2
where θ P is determined by (8) and can be written as
1
  1

θP = Kπ
F + K π
F (8I + K π
F ) < ,
4I 2
where we again use X = 2I. For example, if π F = 9I/(44K ), then θ P = 3/8 and π
V = 1026I/(1331K ). Further, for this (π
V , π
F )
combination, both (24) and (25) are satisfied.
Lastly, we examine how (π F , π V ) changes when π F changes relative to π F and when π V changes relative to π V . Note
that, because θ P increases in π F , we have
   
∂ (πF , πV ) ∂θP 2 πF 1
=− π + − 1− < 0,
∂πF ∂πF V (θ P + 1 )3 (θ P + 1 )2
and
∂ (πF , πV ) 1
= − θ P > 0.
∂πV 2
It follows that Y ≤ 0 if πF ≥ π
F and πV ≤ π
V , and Y > 0 if πF ≤ π
F and πV ≥ π
V , where at least one inequality is strict. 

Proof of Proposition 4. The result θPI ≥ θ P follows immediately from the proof of Propositions 3 and 5. We therefore focus
here on establishing θPI < θ P . When θPI > θ P , we know from Propositions 1 and 5 that θT < θPI and θPI is determined by
da∗ /dθP = H = 0. Using (19), we then obtain
 
d θT d θT
− ( θT X − I ) = K (πF + (θP − θT )πV ) 1 − > 0,
d θP d θP

where the inequality follows because Proposition 2 established that dθ T /dθ P ∈ (0,1). Since −(θT X − I )dθT /dθP > 0 and
dθ T /dθ P > 0, it holds that (θT X − I ) < 0 = (θF B X − I ) and hence θ T < θ FB . Finally, since θ P induces θT = θF B (by definition),
and since θ T increases with θ P , θ T < θ FB implies θPI < θ P . 

Proof of Corollary 1. When θP∗ = θ P , it follows from Proposition 1 that θT = θP∗ = θ P , where θ P < θ FB by Assumption A2.
Since θ T < θ FB , (11) implies that
 
1 1 1 1
a∗ = (θ X − I )dθ < aF B = (θ X − I )dθ .
g θT g θF B
 V. Laux, P.C. Stocken / Journal of Accounting and Economics 65 (2018) 221–236 235

When θP∗ > θ P , we know from Proposition 4 that θ T < θ FB and from Proposition 1 that θ T < θ P . Using (11) and (4) we
obtain
1  θP 1
θT (θ X − I )dθ − θT (πF + πV (θP − θ ) )Kdθ θF B (θ X − I )dθ
a∗ = < aF B = ,
g g
where the inequality follows from θ T < θ FB and θ T < θ P . 

Proof of Proposition 7. Consider part (i) where πF ≥ π F and πV ≤ π V . The proof of Propositions 3 and 5 establishes that
Y ≤ 0 in (20). Thus, the optimal standard is such that θP∗ = θ P = θT . Since the optimal standard is determined by θP∗ = θ P ,
a marginal increase (decrease) in the non-compliance threshold θ P leads to a marginal increase (decrease) in the optimal
standard θP∗ . Applying the implicit function theorem to (8), observe that an increase in enforcement intensity K leads to an
increase in the full-compliance threshold θ P , that is,

dθ P πF ( θ P + 1 ) 2
= >0
X ( θ P + 1 ) − 2I
dK 2

because E [θ ]X − I = 0 implies X (θ P + 1 ) − 2I > 0. Thus, a marginal increase in K leads to an increase in θ P that, in turn,
2

yields an increase in θP∗ .

Consider part (ii) with πF ≤ π F and πV ≥ π V , where at least one inequality is strict. It follows from the proof of
Propositions 3 and 5 that θP∗ > θ P , and that the innovation maximizing standard balances the investment efficiency effect
with the regulatory cost effect so that
da∗ /dθP = H (θP , θT , K ) = 0. (26)
where H is given in (19). To determine how the optimal standard θP∗ responds to changes in enforcement intensity K, sub-
stitute (18) into (26) to obtain
 
−(θT X − I )πV − (πF + (θP − θT )πV ) X − 2I
(θT +1 )2 K
H= = 0.
K πV + X − 2I g
(θT +1 )2
The optimal standard θP∗ therefore solves
 
2I
H1 (θP , θT ) ≡ −(θT X − I )πV − (πF + (θP − θT )πV ) X − = 0, (27)
(θT + 1 )2
where the equilibrium shadow threshold, θ T (K, θ P ), is determined by (9).
Applying the implicit function theorem to (27) yields
∂ H (θ ,θ ) ∂θ (K,θ )
dθP∗ 1
∂θ
P T T
∂K
P

= − ∂ H (θ ,θ ) ∂θT (K,θ ) .
dK 1 P T
∂θT
T P
∂θP + ∂ H1 (θP ,θT )
∂θP
Observe that holding θ T constant, K does not affect H1 and hence θP∗ because K affects both the investment efficiency
effect and the regulatory cost effect. But K affects θP∗ indirectly via its impact on θ T .
To prove dθP∗ /dK < 0, we first show that ∂ θ T /∂ K > 0. Applying the implicit function theorem to (9) yields
∂θT (K, θP ) πF + πV (θP − θT )
= > 0,
∂K K πV + X − 2I 2
(θ +1 ) T

−2
which is positive because θ P > θ T when θP∗ > θ P from Proposition 1 and E [θ ]X − I = 0 implies X − 2I (θT + 1 ) > 0. Further,
observe that
∂ H1 2πF + (1 + 2θP − θT )πV
= −2I < 0,
∂θT (θT + 1 )3
 
∂ H1 2I
= −πV X − < 0.
∂θP (θT + 1 )2
From Proposition 2, we know that ∂ θ T /∂ θ P > 0. Collectively, these results show that dθP∗ /dK < 0; that is, as the enforce-
ment intensity K increases, the optimal standard θP∗ decreases. 

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