Firms’ financial reports are an important source of information for market participants, and relevant disclosure requirements have been imposed by regulators. However, “there is no discussion about the verification requirements of such disclosures,” explain HKUST’s Yan Xiong and colleagues. They offer an alternative explanation for the importance of mandatory certified financial reporting: “to avoid investment distortions caused by managers’ focus on short-term prices.”

Mandatory certification of financial reports is typically justified by positive externalities and reduced agency costs for firms. However, the authors investigate “the real effects of certification and disclosure” by exploring unaddressed core issues: “whether and how certification works differently from disclosure in promoting investment efficiency, whether certification should be mandatory in addition to mandatory disclosure, and how certification costs affect investment decisions.”

To address these issues, the authors develop “a model in which a firm manager selects a project and makes subsequent disclosure and certification decisions regarding the project outcome,” in three regulatory regimes (mandatory certification and disclosure; voluntary certification but mandatory disclosure; voluntary certification and disclosure). They also propose several extensions, namely misreporting by uninformed managers, auditor market power, and managers with long-term incentives.

“Our study has several empirical and policy implications,” the researchers say. Crucially, they discover that “mandating disclosure without mandating certification may result in an even lower investment efficiency than having no mandate at all.” That is, mandatory certification is essential for efficient investment, as it enhances the reliability of financial reports.

This insight is also related to the relevance–reliability tradeoff—a fundamental issue in accounting. “If the information is not reliable,” the authors say, “mandating disclosure under the premise of its relevance alone could result in inefficient investment and decreased social welfare.” This is a critical insight for various areas of accounting practice, ranging from employee stock option disclosures and pension disclosures to ESG disclosure.