Using the setting of hedge funds, I find that audit regulation stifles the misreporting of returns. Not only does the presence of this regulation mitigate misreporting, it also appears to narrow the gap in audit quality between Big 4 and non-Big 4 auditors. Specifically, there is a large difference in audit quality between Big 4 and non-Big 4 auditors when audits are voluntary. However, this difference is not detectable when audits are mandatory, which is consistent with this regulation inducing non-Big 4 auditors to provide higher quality audits. This finding is important in that it suggests that the mere presence of regulation requiring audited financial statements, even in the absence of stringent enforcement by regulatory bodies, has a pronounced effect on the quality of financial reporting. This finding has implications for researchers and regulators seeking to understand how regulation and enforcement influence the quality of financial reporting.
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