# 13-131/VII (2013-09-05)

Suzanne H. Bijkerk, Erasmus University Rotterdam; Vladimir A. Karamychev, Erasmus University Rotterdam; Otto H. Swank, Erasmus University Rotterdam
Cheap Talk, Financial Reporting, Principles-based Regulation, Stochastic Auditing
JEL codes:
D82, M42

We analyze the reporting strategies of firms and the investigation strategies of auditors in an archetype principles-based financial reporting system. To this end, we add a verification stage to a standard cheap-talk game, and apply the resulting game to financial reporting. We show that for a principles-based system to work properly, firms should bear a sufficient share of the cost of a thorough investigation. Furthermore, we find that a principles-based system is a mixed blessing. On the one hand, it leads to a plausible investigation strategy of the auditor, in which "suspected" reports receive most attention. On the other hand, a principles-based system only indirectly weakens firms' incentives to report aggressively.