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Disclosure bias
Abstract
We suggest that transparent bias in management disclosures may result from managers processing information in a heuristic, as distinct from Bayesian, fashion when they face imperfect or head-to-head competition. We predict that transparent bias in disclosures is positively related to the extent of head-to-head competition. In addition, when disclosure is discretionary, we show that managers who exhibit viable, heuristic behavior are less likely to disclose than managers who exhibit Bayesian behavior. Finally, when disclosure is discretionary, we show that the increase in the proportion of uninformed managers who exhibit viable, heuristic behavior encourages more disclosure by an informed manager.
... These studies show, under the adverse selection argument Akerlof (1970), that Voluntary disclosure in the context of convergence with International Accounting Standards in Brazil managers are driven by the market to fully disclose the private information they have. Subsequent studies such as Verrecchia (1983Verrecchia ( , 1990, Dye (1985Dye ( , 1986Dye ( , 1998, Wagenhofer (1990), Kim and Verrecchia (1994), Dye and Sridhar (1995), Fischer and Verrecchia (2004), among others, demonstrate a variety of voluntary disclosure settings that reveal partial disclosure strategies for managers. ...
Purpose:
The purpose of this paper is to verify the influence of the convergence process to International Financial Reporting Standards on the voluntary disclosure of listed Brazilian companies.
Design/methodology/approach:
A voluntary disclosure metric was designed and collected from a random sample of 66 companies registered as active in BM&FBovespa during the 2005-2012 period. For the hypothesis test it was used panel data regressions with random effects.
Findings:
The convergence process to International Financial Reporting Standards is presented as an exogenous factor that affected positively and significantly voluntary disclosure in the analyzed period. It leads to the complementary rationale between mandatory disclosure and the voluntary disclosure.
Originality/value:
The study presents a new metric for measuring the voluntary disclosure level, with the potential to understand the nature of the relationship between this and the mandatory disclosure. In the Brazilian capital market context, governed by the stakeholder model, convergence to International Financial Reporting Standards induced an increase on voluntary disclosure quality.
... Few models have captured this trade-off because most of them look at either overstatements or productive effort, but not both. For example, Fischer and Verrecchia (2004) and Stein (1989) do not consider the agent's productive effort or the optimal contract. Gibbons and Murphy (1992) and Holmström (1999) do not consider the agent's overstatement. ...
Chapter 1 is a critique of a highly influential paper in corporate governance. Chhaochharia and Grinstein (2009) estimate that CEO pay decreases 17% more in firms that were not compliant with the recent NYSE/Nasdaq board independence requirement than in firms that were compliant. We document that 74% of this magnitude is attributable to two outliers out of 865 sample firms. In addition, we find that the compensation committee independence requirement increases CEO total pay, particularly in the presence of effective shareholder monitoring. Our evidence casts doubt on the effectiveness of independent directors in constraining CEO pay as suggested by the managerial power hypothesis.
In chapter 2, we investigate whether the earnings overstatements that led to the Sarbanes-Oxley Act (SOX) may have been an intended consequence of pay-for-performance. We find that incentives were higher when current shareholders stood to benefit from overstatements by selling their shares at inflated prices. Incentives also fell in response to the additional costs imposed by SOX, and the decrease is concentrated in firms whose shareholders benefit from overstatements. If overstatements were a symptom of the agency conflict, incentives should have increased around SOX to induce more productive effort as managers voluntarily cut back on overstatements. The empirical evidence thus rejects the view that earnings overstatements prior to 2002 were an unintended consequence of pay-for-performance.
In chapter 3, we explore the relationship between obesity and household credit risk. Obesity is a known health risk factor and carries a social stigma. Its presence provides a potentially informative signal about individuals' choices and preferences. Using NLSY survey data, we estimate that the loan delinquency rate among the obese is 20% higher than among the non-obese after controlling for numerous observable, prohibited, and - to lenders - unobservable credit risk factors. The economic significance of obesity for delinquencies is comparable to that of job displacements. Obesity is particularly informative about future delinquencies among those with low credit risk. In terms of channels, we find that the obesity effect is at least partially mediated through poor health, but is not attributable to individuals' time preferences.
... Jorgensen and Kirschenheiter …nd that the …rms'propensity to issue reports depends on the extent and sign of their correlation. Bagnoli and Watts (2010) and Fischer and Verrecchia (2004) analyze bias in settings with multiple …rms who engage in product market competition. Strobl (2013) investigates cost of capital implications from …rms' biasing behavior in a setting where a given number of …rms have to disclose earnings. ...
This paper studies the propensity of firms to commit to disclose information that is subsequently biased, in the presence of other firms also issuing potentially biased information. An important aspect of such an analysis is the fact that firms can choose whether to disclose or withhold information. We show that allowing the number of disclosed reports to be endogenous introduces a countervailing force to some of the empirical predictions from the prior literature. For example, we find that as more firms issue reports or as the correlation across firms’ cash flows increases, the firm biases its report less. However, when we treat firms’ disclosure choices as endogenous, we show that the number of firms that commit to disclose decreases as the correlation across these cash flows increases, and this, in turn, offsets the direct effect of the correlation on bias.
This paper was accepted by Mary Barth, accounting.
... Few models have captured this tradeoff because most of them look at either overstatements or productive effort, but not both. For example, Stein (1989) and Fischer and Verrecchia (2004) do not consider the agent's productive effort or the optimal contract. Gibbons and Murphy (1992) and Holmström (1999) do not consider the agent's overstatement. ...
If overstatements were a symptom of the agency conflict, pay-for-performance sensitivities should have increased in response to the additional penalties for misreporting imposed by SOX. Our finding of their decrease is inconsistent with the view that overstatements were an unintended consequence of incentive pay prior to 2002. To corroborate our interpretation, we show that (i) CEO pay-for-performance sensitivities are higher among firms whose shareholders stand to benefit from overstatements; (ii) this cross-sectional relationship weakens significantly after SOX; and (iii) the within-firm decrease in pay-for-performance sensitivity is most pronounced among firms with high pre-SOX shareholder benefits from overstatements.
... captures that there are diminishing returns to investment ( [46]). We also assume that the π j 's are uncorrelated across firms. ...
The primary goal of this study is to provide a theoretical model that shows explicit solutions for equilibrium prices and derives the equilibrium required return for the firm’s stock price. In other words, this theoretical study provides a direct link between accounting information, related to the firm’s reports, and the cost of capital within an equilibrium setting. Accounting information is judged to be of high value because it affects the market’s ability to direct firms’ capital allocation choices. The findings showed that an increase in expected cash flows, coming from improvements in the quality of accounting information, leads to a reduction in the firm’s cost of capital.
... captures that there are diminishing returns to investment ( [46]). We also assume that the π j 's are uncorrelated across firms. ...
The primary goal of this study is to provide a theoretical model that shows explicit solutions for equilibrium prices and derives the equilibrium required return for the firm's stock price. In other words, this theoretical study provides a direct link between accounting information, related to the firm's reports, and the cost of capital within an equilibrium setting. Accounting information is judged to be of high value because it affects the market's ability to direct firms' capital allocation choices. The findings showed that an increase in ex-pected cash flows, coming from improvements in the quality of accounting information, leads to a reduction in the firm's cost of capital.
Management earnings forecasts have received significant attention as an important source for setting firm expectations. Our paper argues that how these forecasts are presented to the public is important for managing these expectations. We present both analytical and empirical analyses demonstrating that managers’ disclosure framing choices will depend on the information type, managerial overoptimism, and managerial compensation structures. We also provide evidence showing that disclosure framing choices can dampen stock return volatility. Finally, we indicate that disclosure strategies alter the misreporting results found in Guttman et al. (2006).
We examine the effect of managerial overoptimism on discretionary disclosure choices. In efficient capital markets, overoptimism should matter for disclosure outcomes only if the disclosed information represents the manager's subjective expectation and the market is unaware of the precise bias of the manager. In these cases, firms run by overoptimistic managers are overvalued, providing novel implications for disclosure-based trading strategies and managerial hiring decisions of shareholders. Finally, the disclosure outcome depends crucially on the subjectivity of the disclosed information, the manager’s overoptimism, and overall market sentiment.
Research on the impact of transparency and disclosures (TD) on the firm’s valuation presents an ambiguous result. The effect of disclosure on value is a concern because disclosure is not an economic activity. It grows further due to the embellishment of positive disclosures and the suppression of hostile facts. This situation has motivated the authors to conduct the current research. The study aims to empirically find the influence of TD on the valuation of banks in India while the Environmental, Social, and Governance Index (esgi), Shareholder activism index (shai), and Lerner Index (li) act as moderators. A panel data regression (PDR) is adopted to analyse the data in the study. Panel data for 31 public/private banks for ten years (2010–2019) are collated. The authors used econometric models to understand the linear, quadratic, and interaction association of Transparency and Disclosure (TD) with the valuation of the banks in India. It is empirically found that TD alone does not impact the valuation of banks but is positively associated with a bank’s value under the influence of the moderators, Environmental, Social, and Governance variables (esgi), and shareholder activism (shai).
This paper studies the link between corporate sustainability and failure risk. The two competing hypotheses rely on the controversies in the theoretical and empirical literature linking sustainability and financial performance. Analysis of a sample of Estonian non-listed companies of all sizes indicates that firms engaged in more sustainability initiatives exhibit a higher risk of failure in the short run. The results remain robust for different sustainability initiatives and periods, while being exclusively determined by firms active locally, not on foreign markets.
A firm’s publicly available information reflects ex ante committed information releases and ex post discretionary disclosures. In a setting wherein a firm’s CEO is concerned with stock market valuation and confrontations with the employee union, this paper endogenizes when the CEO retains ex post disclosure discretion and when the CEO curtails discretion, opting instead to ex ante commit to not gathering information or publicly disclosing information. The underlying economic forces entail a trade-off between the time-inconsistency problem (the CEO’s ex post preferences can diverge from the CEO’s ex ante goals) and how silence (absence of information) under the ex ante and ex post paths is valued differentially by the union. In effect, silence under different systems “speaks” differently, and this influences both the labor union’s incentives to engage in bargaining with the firm and the stock market’s pricing of the firm’s equity.
This paper was accepted by Ranjani Krishnan, accounting.
Effective financial reporting requires efficient information processing. This paper studies factors that determine efficient information processing. I exploit a unique small business lending setting where I am able to observe the entire codified demographic and accounting information set that loan officers use to make decisions. I decompose the loan officers’ decisions into a part driven by codified hard information and a part driven by uncodified soft information. I show that a machine learning model substantially outperforms loan officers in processing hard information. Loan officers can only process a sparse set of useful hard information identified by the machine learning model and focus their attention on salient signals such as large jumps in cash flows. However, the loan officers use salient hard information as “red flags” to highlight where to acquire more soft information. This result suggests that salient information is an attention allocation device: It guides humans to allocate their limited cognitive resources to acquire soft information, a task in which humans have an advantage over machines. This article is protected by copyright. All rights reserved
In this paper, we examine whether a regulatory shift allowing more private firm disclosure leads to less myopia. The Jumpstart Our Business Startups (JOBS) Act of 2012 permits a subset of firms to meet privately with potential investors in the months before an IPO, allowing them to provide information without proprietary cost concerns, leading to more complete disclosure. Consistent with a reduction in myopia, we find that these firms are less likely to manage earnings to beat short-term benchmarks, are punished less harshly by the market (via stock price declines) when they do miss the earnings benchmark, and provide fewer short-horizon forecasts. We also find that firm disclosures are less short-term focused, investors have longer holding periods than do those same investors in non-JOBS Act IPO firms and that these firms attract more long-term investors. Our results hold (i) across the subsample of firms for which other JOBS Act provisions were already present, and (ii) after controlling for those other provisions, consistent with private discussions acting as the primary mechanism. Our results are also strongest for firms with higher proprietary costs, consistent with private disclosure reducing myopia by reducing proprietary cost concerns. Collectively, this evidence suggests that when firms are able to privately disclose information to investors, both firms and investors become less myopic.
We investigate the joint effects of auditor's reporting choice and audit committee effectiveness on management disclosures about complex estimates. A new PCAOB standard requires auditors to report on Critical Audit Matters (CAMs): issues "communicated or required to be communicated to the audit committee" about accounts or disclosures that (1) "are material to the financial statements" and (2) "involved especially challenging, subjective, or complex auditor judgment" (PCAOB 2017a, 11). Consistent with investor arguments, we find that audit committee effectiveness and more detailed CAM reporting encourage managers' disclosures of the risk underlying complex estimates. When the auditor's report is more informative about a complex estimate and the audit committee is more effective, management's related financial disclosures are more forthcoming. However, less informative auditor disclosures or more effective audit committees alone do not prompt greater management disclosure. Thus, expanded auditor reporting and more effective audit committees, together, can enhance the disclosures investors value.
In this study, we investigate whether and to what extent institutional shareholders' political values influence their investees' environmental disclosure and performance. Using employees' political donation data, we construct institutional investors' political ideology score, which higher (lower) value represents a more Republican- (Democratic)-leaning culture. We find that firms led by institutional shareholders with a more Republican-oriented political ideology are less likely to issue environmental reports. Such a negative effect is more pronounced for firms with institutional shareholders with long-term horizons, with high corporate Republican ideology scores, and without an environmental committee. We further find that institutional shareholders' Republican-oriented political values are negatively associated with their investee firms' environmental performance and green innovations. Overall, our results indicate that institutional shareholders' internal political polarization significantly influences corporate environmental disclosure policies.
We introduce real decisions (a project choice decision, an investment scale decision, and an information acquisition decision) to the Dye (1985) voluntary disclosure framework and examine how the prospect of voluntary disclosure affects managers' real decisions. Riskier projects lead to more volatile environment and hence entail higher efficiency loss at the subsequent investment scale decision stage if managers are uninformed. If managers are informed, they can withhold bad information, and the value of this option is higher for riskier projects. We show that the voluntary nature of managers' disclosure may lead to two types of inefficiencies: (1) managers may choose riskier projects, which generate lower expected cash flow due to the higher efficiency loss at the subsequent decision stage, and (2) managers may overinvest in information acquisition, because informed managers with bad information have the option to pool with uninformed mangers and benefit from being overpriced.
Competitors often pay close attention to rivals’ financial reports. For firms with high levels of proprietary information, competition may increase the costs of public disclosure. Theory suggests that such costs, which we refer to as the proprietary costs of financial reporting, may lead to strategic financial reporting. We find that financial statement comparability is decreasing in the proprietary costs of financial reporting. Our results are robust to the use of alternative measures of comparability and alternative measures of proprietary costs of financial reporting. In addition, theory suggests that financial reports will contain stronger signals of managers’ private information when information asymmetry is high. We show that the negative relation between the proprietary costs of financial reporting and financial statement comparability is stronger for firms with poorer information environments. Together, our findings suggest that through the discretion afforded in Generally Accepted Accounting Principles (GAAP), managers of firms with high levels of proprietary information report in a way that reduces the comparability of their financial statements, particularly when information asymmetry is high.
The aim of this research is to understand management behaviour in financial statement representation. Sincerity is the starting point for building the desired behavior as explained in this paper. In Indonesia, research relating to the complicated issue of financial statements-and the representation of these (including their reporting)-is seldom addressed. Therefore, this particular research has been completed in-country (Indonesia) with the focus being made on the Synod of the Protestant Christian Church in Bali (GKPB). The Hermenutika Ontik approach, also known as the textual and contextual interpretation method, has been used as the fundamental principle for research. The understanding and practice of contextual interpretation is based on the concept of Immanuel Kant. Both the Theory of Planned Behavior and the Theory of Misbehavior have been utilized throughout the research of this paper to construct the representation of the behaviour principle. All reflections have been based on the Ten Commandments of God. Research results emphasise the fact that representations of the behavioural principle for financial statements arise from two behavioural dynamics: subudi and durbudi. The behavioural dynamic of subudi is directional and consists of thought, intention and conduct/action. Meanwhile, the behavioural dynamic of durbudi is indirectional. The resultant of directional behavior (aka subudi) is the construction of representation behavioural principles for financial statements encompassing the three mandates of the church (koinonia, diakonia, and marturia) and explained in this paper as being TAHIR ILAHI.
A comprehensive definition of earnings management should take into consideration its characteristics, conditions, activities, and targets. Such a definition allows distinguishing earnings management from other activities like fraud, earnings quality, impression management, and expectation management. Managers may use different methods to manage earnings including accrual earnings management, real earnings management, earnings smoothing, income shifting, and other advanced techniques. They trade-off between these methods based on their costs and benefits to their firms and own welfare. Although different models have been introduced to measure the previous activities, most of them focused on accrual earnings management. These models suffer from shortcomings that can be mitigated by developing new models, paying more attention to measuring activities other than accrual earnings management, analysing more than one activity at a time, using more than one model to measure the same activity, and adopting qualitative methodology.
We study the choice of disclosure and share repurchase strategies of informed managers using a model that captures how they differentially impact short and long-term stock value. We identify a partial disclosure equilibrium in which firms in the lowest value region neither disclose nor repurchase, firms with intermediate values disclose but do not repurchase, and firms in the highest value region induce undervaluation by not disclosing and buy back shares. In particular, the well known unraveling result when the manager is always informed (and when disclosure is costless) — the typical upper-tailed disclosure region in classic voluntary disclosure models — need not obtain when informed managers can use repurchases to extract information rents. We offer a new perspective on open-market share repurchases — the most common form of share repurchases — when chosen optimally with disclosure. Our analysis indicates that the equilibrium disclosure region shrinks as the firm's stock trading liquidity increases.
SYNOPSIS
The objective of this paper is to cohesively introduce the notion of natural optimism into the accounting literature and to provide insights into the role of natural optimism in financial reporting on the part of firm managers. To accomplish this, we first discuss the research that demonstrates that optimism is the natural state of mind for most people and therefore we posit that firm managers involved in preparing financial statements are likely to exhibit naturally occurring optimism. Second, we identify where natural optimism is most likely to have an impact on financial reporting. Third, we address the challenges involved with mitigating or eliminating natural optimism in financial reporting. Finally, we address the relationship between optimism and two other constructs often found in accounting—namely, overconfidence and motivated reasoning.
This work reviews and illustrates potentially misleading disclosure practices which may respond to opportunistic management behavior. We focus on press releases announcing annual earnings posted on company websites. The complexity of corporate communication practices has increased over time providing users with elaborate reports including detailed information on company annual results. Additionally, companies also issue press releases summarizing the annual results. These press releases are essential for a firm’s disclosure strategy, and are accessible to investors and the general public through company websites and news wire services. They are fundamental for a timely presentation of a firm’s performance, potentially influencing the perceptions of the reader. The negative aspect of these press releases is that their content is unregulated, and managers can select and present the information in a misleading way. Our objective is to identify the strategies used to do so. The practices analyzed in this work are subtle techniques which may not be easy to detect. The identification of these practices is relevant for the different parties involved or those affected by corporate disclosures. Decisions taken using this potentially biased information is likely to have an effect on the efficient allocation of economic resources. Therefore, the contribution of this research is important and relevant in order to extend corporate communication research.
This monograph surveys the analytic accounting disclosure literature in which firms strategically communicate information to investors. Its purpose is to identify guidelines that firm management might consider when voluntarily disclosing or mandatorily reporting information to investors and also factors that investors might recognize when using a firm's disclosure. It discusses persuasion games, costless signaling games, and costly signaling games. The monograph highlights the primary features of the equilibria in these games and how communication varies in each of these settings. It then surveys work that uses these frameworks. This work suggests that a firm's disclosure policy depends on the features of its environment. The monograph concludes that characterizing firm disclosure policies for a set of generic features of the reporting environment awaits further research.
The argument of proprietary costs is commonly used by firms to object against proposed disclosure regulations. The goal of this paper is to improve our understanding of the welfare consequences of disclosure in duopoly markets and to identify market settings where proprietary costs are a viable argument for firms to remain silent. We, therefore, solve the optimal disclosure strategies and distinguish two different potentially costly effects of disclosing private information: the strategic information effect and the market information effect. We identify the market settings for which a regulator prefers to impose disclosure regulation so as to maximise consumer surplus or total surplus. Regulation may be necessary because (i) the increase in welfare outweighs proprietary costs to the firms, or (ii) firms are trapped in a prisoners' dilemma. The first primarily applies to Bertrand competition with demand uncertainty and, to a lesser extent, to Cournot competition. The second applies primarily to Cournot competition and Bertrand competition with cost uncertainty.
This research supports the case for introducing mandatory portfolio holdings disclosure regimes in Australia and New Zealand. Of the 22 nations (constituents of the MSCI World Index) surveyed in the 2011 Morningstar Global Investors Report, these are the only two countries that do not require disclosure. Even without compulsory disclosure, some funds do choose to disclose. We examine the potential effects of mandated holdings disclosure on mutual fund returns by using the voluntary holdings disclosures as a proxy for mandatory disclosure. We find that low-ranked (on abnormal returns) New Zealand funds following the Global Financial Crisis (GFC), and Australian low-rank funds both before and after the Crisis, would have improved performance with mandatory disclosure. In contrast, returns would drop for Australian high-rank funds. This suggests that disclosure may be costly for high-rank funds due to front-running, while it provides benefits for low-rank funds due to the enhanced monitoring abilities of investors. We also examine whether investors care about disclosure, by measuring fund flows. We find evidence that following the GFC, the importance of transparency has increased for investors in high-rank New Zealand funds, while investors in Australian funds show no preference for disclosure after the Crisis. On balance, we believe the introduction of mandatory disclosure schemes in Australia and New Zealand would represent a significant advance for the industry and bring benefits to investors.
Effective audits are claimed to not only enhance the detection of fraud but also the deterrence of potential fraud. We conduct an experiment with 167 senior corporate managers in which we examine whether changes in auditor actions and behaviours consistent with auditors exhibiting a heightened level of professional scepticism deter managers from committing corporate malfeasance. We examine three audit action changes: an increase in management inquiry rigour, an increase in the extent of the audit sample and a change in the nature of the audit tests. All of these changes are situated in an experimental design where the objective probability of detecting managerial malfeasance does not change and managerial malfeasance can occur in the same period as the audit action changes. We find that changing the nature of the evidence collected decreases participating managers’ intention to commit corporate malfeasance. Furthermore, we find that the most common auditor response in practice, increasing the extent of the sample without changing tests, does not reduce managers’ intention to commit malfeasance. Finally, we find that combining the use of more critical client questioning with increasing extent of testing does result in less managerial intent to commit malfeasance. Implications of these findings are discussed.
This paper establishes linkages among corporate myopia, demand forecast, marketing efforts, and production planning. It shows that the option of discretionary disclosures and managerial myopia do not necessarily distort the operational activities such as marketing campaign and production, but do induce less investments in forecast precision than a benchmark does.
The tendency to rely on accounting earnings as the primary metric of corporate performance has been subject to criticism in recent times. A key concern is that earnings misrepresent changes in value in that cash outlays occur upfront but expenses are recognized only over time. While recognized expenses indeed add up to the initial cash outflow, the equality holds only in undiscounted (nominal), not discounted (real), terms. Accordingly, corporate earnings figures suffer from a form of money illusion. In this paper, we demonstrate that such money illusion can have an upside when it is present in vertical relationships subject to self-interest. In particular, a buyer who focuses on earnings has incentives to increase purchases since it does not immediately encounter the full cost of cash outflows. These added incentives can promote more efficient trade. We also show that the increased incentives to buy can also lead to Pareto improvements by spurring the supplier to invest more in developing technology. Finally, we demonstrate that judiciously chosen inventory valuation rules can lead to efficient supply chain outcomes. Thus, efficiency can be achieved when supply chain parties freely trade and regulators specify only the accounting rules under which they operate.
This paper addresses the contracting implications of New Economy firms: informal, flexible organizations predominantly staffed by younger workers. The model incorporates two findings from the behavioral economics literature. First, workers may overestimate their own productivity (optimism). Second, workers may be monitoring-averse, with intense monitoring undermining intrinsic motivation. The combination of behavioral traits and work setting has deleterious consequences for workers. Despite higher monetary compensation and sometimes weaker incentives, they work harder and experience a higher disutility of effort than conventional workers, and also have a utility realization that is lower on average than their reservation utility. Optimism and monitoring-aversion are mutually reinforcing. In contrast to standard agency models, both high- and low-type unconventional workers benefit from private information. The utility shortfall, however, may persist despite the rent extraction.
We study a model in which managers' disclosure and investment decisions are both endogenous and managers can manipulate their voluntary reports through (suboptimal) investment, financing or operating decisions. Managers are privately informed about the value of their firm and have incentives to voluntarily disclose information and manipulate their reports in order to obtain more favorable terms when issuing equity to finance a new profitable investment opportunity. The model shows that treating managers' disclosure and investment decisions both as endogenous and allowing managers to manipulate their voluntary reports yields qualitatively different predictions than when the disclosure and investment decisions are considered separately and managers cannot engage in manipulation. The model predicts that managers' disclosure strategy is sometimes characterized by two distinct non-disclosure intervals (contrary to traditional threshold equilibria of voluntary disclosure models) and that managers with intermediate news sometimes forego the new profitable investment opportunity (in contrast to Myers and Majluf 1984). As such, the paper highlights the importance of considering the interdependencies between firms' disclosure and investment decisions and provides new empirical predictions.
We examine how biased financial reports (managed earnings) affect how firms compete in the product market and how product market competition affects incentives to bias reported earnings. We find that Cournot competitors bias their financial reports so as to create the impression that their costs of production are lower than they actually are. This bias leads to lower total production, a higher price and each competitor earning greater product market profits. These results obtain even though no firm is fooled by its rival's disclosure. We also find that the magnitude of the bias (the amount of earnings management) is larger when firms compete in more profitable product markets but smaller when they can extract more information about their rival's costs from their own. When the costs of misreporting are asymmetric, the lower cost firm engages in more earnings management than its rival, and it produces more and earns greater profits than it would in a full-information environment. Our analysis also offers new, testable implications for the relationship between earnings management, reported and actual earnings and industry structure.
We study a firm’s strategy for acquisition and disclosure of operational information by establishing linkages among information quality, managerial self-interest, and production planning. We develop a multi-stage model in which a manager of a publicly traded firm first receives private information about the product demand and then uses it to make production and disclosure decisions. We consider two prevalent disclosure models employed in the accounting literature: all-or-nothing and cheap-talk models. In the all-or-nothing model, it is assumed that any disclosure must be truthful, but the manager can strategically withhold information. We show that the manager commits to acquire the value-added operational information if i) the managerial self-interest in the interim share price is low or ii) the managerial self-interest in the interim share price is high, but the fixed disclosure cost is either sufficiently low or sufficiently high. We demonstrate that the firm is better off if the production level is observable to the financial market because multi-dimensional signaling reduces costs. In the cheap-talk model, the quality of the disclosure is endogenous. We prove that the equilibrium is a partitioning equilibrium and demonstrate that the manager’s incentive to acquire value-added operational information is increasing in the penalty cost for misleading investors.
We examine how the threat of litigation affects an entrepreneur’s reporting behavior when the entrepreneur (i) can misrepresent his privately observed information, (ii) pays legal damages out of his own pocket, and (iii) is optimistic about the firm’s prospects relative to investors. We find higher expected legal penalties imposed on the culpable entrepreneur do not always cause the entrepreneur to be more cautious but instead can increase misreporting. We highlight how this relation depends crucially on the extent of entrepreneurial overoptimism, legal frictions, and the internal control environment.
Fischer and Verrecchia (J. Account. Econom. (2004), forthcoming) studies a model of imperfect competition in which firms’ disclosures are affected by biased information processing. They find that optimism can add punch to a firm's actions. When facing an optimist, a rival is forced to soften its competitive posture, thereby rendering such biases viable. Although the setting provides a cogent explanation for disclosure bias, its reliance on imperfect information processing introduces some questions. One concern is the ease with which polar results can be obtained when the rules-of-the-game are sufficiently relaxed. The discussion provides examples illustrating this and related issues.
The corporate information environment develops endogenously as a consequence of information asymmetries and agency problems between investors, entrepreneurs, and managers. We review current research on the three main decisions that shape the corporate information environment in capital market settings: (1) managers’ voluntary disclosure decisions, (2) disclosures mandated by regulators, and (3) reporting decisions by analysts. We conclude that, in the last ten years, research has generated several useful insights. Despite this progress, we call for researchers to consider interdependencies between the various decisions that shape the corporate information environment and suggest new and interesting issues for researchers to address.
Competitors have information about their rival's business that, if known to the rival, would be useful in its decision-making. We identify a proprietary benefit to disclosing such information: firms that have information about their rivals that may be private, tell. This result is very robust and does not depend on whether the firms are Cournot or Bertrand competitors, the amount of information the disclosing firm has, or the degree of product heterogeneity. Our results contrast with the results in the literature in which the firm has information about its own customers or costs. In that case, the chosen disclosure policy depends on the type of private information and whether the competing firms' strategies are substitutes or complements.
JEL Classifications: G1; G14; M41.
The controversy about the choice among accounting alternatives is often based on arguments suggesting heuristic behaviour by market participants and firm managers. Debates focus on whether accounting methodology systematically alters reported earnings and whether this effect may add or subtract economic value independently of any effect on underlying cash flows. Arguments based on heuristic behaviour of firms’ management and investors influence decisions about the applicability of standards and regulation.
Do firms with separate owners and managers maximize profits? We address this question for an oligopoly where managers compete in quantities or prices, as in the Cournot or Bertrand models, and owners choose their managers' incentives. We find that there is a strategic aspect in the problem of selecting incentives and that profit-maximizing behavior does not result. In particular, in the oligopoly we study, the behavior of firms competing in quantity (price) more closely resembles perfectly competitive (collusive) behavior than Cournot (Bertrand) behavior.
It is proposed that motivation may affect reasoning through reliance on a biased set of cognitive processes--that is, strategies for accessing, constructing, and evaluating beliefs. The motivation to be accurate enhances use of those beliefs and strategies that are considered most appropriate, whereas the motivation to arrive at particular conclusions enhances use of those that are considered most likely to yield the desired conclusion. There is considerable evidence that people are more likely to arrive at conclusions that they want to arrive at, but their ability to do so is constrained by their ability to construct seemingly reasonable justifications for these conclusions. These ideas can account for a wide variety of research concerned with motivated reasoning.
The authors examine the incentives which competing principals give their agents, focusing on two oligopoly models where owners write incentive contracts with the ir managers. Under Cournot quantity competition, each manager's margi nal payment for production will exceed the firm's marginal profit. De viations from profit maximization are reduced by ex ante uncertainty about costs and increased by ex ante correlation between the firms' c osts. In contrast, in a differentiated goods market with price compet ition, managers receive less than their marginal profit. In general, a principal will distort his agent's incentives when the agent compet es with agents of competing principals. Copyright 1987 by American Economic Association.
We characterize the steady-state equilibrium in which informed traders who exhibit heuristic (i.e., representativeness, as opposed to Bayesian) and Bayesian behaviors achieve the same expected utility. Then, we show how the endogenous, steady-state proportion of heuristic traders is affected by the quality of public information and other exogenous features of our model. Finally, we discuss how the presence of heuristic traders potentially alters the link between improved public disclosure and: market liquidity, the variance in the change in price, and market efficiency.
We explore how competitive disadvantage affects firms' incentives to disclose or withhold infor Mation of common interest to competing firms within a Cournot duopoly. We establish the existence of a unique disclosure equilibrium to the problem of firms disclosing private infor Mation about aggregate demand, and show that firms choose to withhold infor Mation of either very high or very low demand. We also show that both the size of the disclosure interval and ex ante probability of disclosure decreases as the intensity of competition between firms increases.
In this paper we model a firm's choice of how finely to report its segmental performance, given that its disclosures will be observed by both a rival firm and the capital market. We find that when competition with the rival is sufficiently severe, the firm's value is highest when its privately-observed signals are sufficiently similar and it discloses these signals as separate segments. In this case the capital market becomes better informed yet the rival firm learns very little about where to allocate its capital. Consequently, in equilibrium, only firms with sufficiently similar results from their different activities will choose to report them as separate segments; firms with disparate results will aggregate them together into a single reported segment.
The purpose of this paper is two-fold. First, I attempt a taxonomy of the extant accounting literature on disclosure: that is, a categorization of the various models of disclosure in the literature into well-integrated topics. With regard to the taxonomy, I suggest three broad categories of disclosure research in accounting. The first category, which I dub “association-based disclosure”, is work that studies the effect of exogenous disclosure on the cumulative change or disruption in investors’ individual actions, primarily through the behavior of asset equilibrium prices and trading volume. The second category, which I dub “discretionary-based disclosure”, is work that examines how managers and/or firms exercise discretion with regard to the disclosure of information about which they may have knowledge. The third category, which I dub “efficiency-based disclosure”, is work that discusses which disclosure arrangements are preferred in the absence of prior knowledge of the information, that is, preferred unconditionally. Then, in the final section of the paper, I recommend information asymmetry reduction as one potential starting point for a comprehensive theory of disclosure. That is, I recommend information asymmetry reduction as a vehicle to integrate the efficiency of disclosure choice, the incentives to disclose, and the endogeneity of the capital market process as it involves the interactions among individual and diverse investors.
Studies examining managerial accounting decisions postulate that executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation. The empirical results of these studies are conflicting. This paper analyzes the format of typical bonus contracts, providing a more complete characterization of their accounting incentive effects than earlier studies. The test results suggest that (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan.
In a duopoly model where firms have private information about an uncertain linear demand, it is shown that if the goods are substitutes (not) to share information is a dominant strategy for each firm in Bertrand (Cournot) competition. If the goods are complements the result is reversed. Furthermore the following welfare results are obtained: 1.(i) With substitutes in Cournot competition the market outcome is never optimal with respect to information sharing but it may be optimal in Bertrand competition if the products are good substitutes. With complements the market outcome is always optimal.2.(ii) Bertrand competition is more efficient than Cournot competition.3.(iii) The private value of information to the firms is always positive but the social value of information is positive in Cournot and negative in Bertrand competition.
This paper examines accounting changes, costs of default, and accounting-based covenants violated by 130 firms reporting violations in annual reports. I find that managers of firms approaching default respond with income-increasing accounting changes and that the default costs imposed by lenders and the accounting flexibility available to managers are important determinants of managers' accounting responses. I also document that private lending agreements are the first violated, that net worth and working capital restrictions are the most frequently violated restrictions, and that in 52 percent of the cases lenders require concessions from borrowers to resolve default.
This article analyzes the effect of a firm's capital structure on its product market strategy in the context of a model of repeated oligopoly. I show that there exists an upper bound on the firm's debt level in the absence of bankruptcy costs. This bound depends on the number of firms in the industry, the discount rate, the elasticity of demand, and other related factors that affect product market equilibrium in oligopolies. I also show that warrants may decrease equilibrium output in oligopolies and that convertible debt and warrants may be used to raise the upper bound on the debt level in specific cases. I show that the effect of capacity constraints on optimal capital structure is nonmonotonic.
This article examines the incentives for Cournot oligopolists to share information about a common parameter or about firm-specific parameters. We assume that the private information that firms receive has equal accuracy and obeys a linear conditional expectation property. We find that when the uncertainty is about a firm-specific parameter, perfect revelation is the unique equilibrium. When the uncertainty is about a common parameter, no information sharing is the unique equilibrium. But the nonpooling equilibrium converges to the situation where the pooling strategies are adopted as the total amount of information increases. Hence, the efficiency is achieved in the competitive equilibrium as the number of firms becomes large.
Two steps are required for firms collusively to restrict output in stochastic markets. Firms must homogenize their market estimates by pooling information and they must cooperatively allocate production levels. In this article I examine the incentives for firms to share private information about a stochastic market. I show that there is never a mutual incentive for all firms in an industry to share unless they may cooperate on strategy once information has been shared. This situation is unfortunate, as society's welfare is maximized only when firms share information, but act competitively.
This article studies the fulfilled expectations equilibrium for a Cournot duopoly model in which firms acquire information about uncertain linear demand. Several propositions are established concerning the incentives to acquire and release information in this duopoly environment.
This is an article about modeling methods in information economics. A notion of "favorableness" of news is introduced, characterized, and applied to four simple models. In the equilibria of these models, (1) the arrival of good news about a firm's prospects always causes its share price to rise, (2) more favorable evidence about an agent's effort leads the principal to pay a larger bonus, (3) buyers expect that any product information withheld by a salesman is unfavorable to his product, and (4) bidders figure that low bids by their competitors signal a low value for the object being sold.
This article proposes a theory of corporate transparency and its determinants. We show that under imperfect product market competition, the corporate transparency decision affects the value of equity and debt claims differently. We then embed this insight in a model of endogenous investor influence in which banks may emerge as dominant investors. In line with evidence from continental Europe and Japan, we find that dominant creditors seek to decrease transparency below the level preferred by equity holders. The theory predicts a clustering of firm characteristics that emerge when capital markets are not sufficiently investor friendly to allow arm's-length monitoring: bank dominance, opaqueness, uncertainty about assets in place, low variability of profits, and reduced average profits.
This article proposes a theory of corporate transparency and its determinants. We show that under imperfect product market competition, the corporate transparency decision affects the value of equity and debt claims differently. We then embed this insight in a model of endogenous investor influence in which banks may emerge as dominant investors. In line with evidence from continental Europe and Japan, we find that dominant creditors seek to decrease transparency below the level preferred by equity holders. The theory predicts a clustering of firm characteristics that emerge when capital markets are not sufficiently investor friendly to allow arm's-length monitoring: bank dominance, opaqueness, uncertainty about assets in place, low variability of profits, and reduced average profits.
A blush may reveal a lie and cause great embarrassment at the moment. But in situations that require trust, there can be great advantage in being known to be a blusher. This paper develops a model in which tastes are determined endogenously for their capacity to help solve an important class of market failures. The common feature of these market failures is that they require people to bind themselves to courses of action that will later seem unattractive. The tastes that emerge are very different from the ones assumed in conventional rational-choice models. Copyright 1987 by American Economic Association.
We consider an oligopolistic market where firms face an uncertain demand for their product. Each firm observes a private signal for the state of demand and decides whether to reveal it to other firms and how complete this revelation will be. After the stage of information transmission the firm chooses its level of output. We derive pure strategy equilibria that are symmetric and subgame perfect, and demonstrate that no information sharing is the unique Nash equilibrium of the game regardless of the degree of correlation among the private signals.
The theory of large-scale entry into an industry is made complicated by its game-theoretic aspects. Even in the simplest case of one established firm facing one prospective entrant, there are some subtle strategic interactions. The established firm's pre-entry decisions can influence the prospective entrant's view of what will happen if he enters, and the established firm will try to exploit this possibility to its own advantage.
We examine how incentives for two duopolists to honestly share information change depending upon the nature of competition
(Cournot or Bertrand) and the nature of the information structure. While in earlier papers uncertainty is about an unknown
common demand intercept, in the present paper uncertainty is about unknown private costs. The different information structure
reverses the incentives to share information. While with unknown common demand sharing is a dominant strategy with Bertrand
competition and concealing is a dominant strategy with Cournot competition, with unknown private costs sharing is a dominant
strategy with Cournot competition and concealing is a dominant strategy with Bertrand competition.
This article proposes a theory of corporate transparency and its determinants. We show that under imperfect product market competition, the corporate transparency decision affects the value of equity and debt claims differently. We then embed this insight in a model of endogenous investor influence in which banks may emerge as dominant investors. In line with evidence from continental Europe and Japan, we find that dominant creditors seek to decrease transparency below the level preferred by equity holders. The theory predicts a clustering of firm characteristics that emerge when capital markets are not sufficiently investor friendly to allow arm's-length monitoring: bank dominance, opaqueness, uncertainty about assets in place, low variability of profits, and reduced average profits.
Corruption in the public sector erodes tax compliance and leads to higher tax evasion. Moreover, corrupt public officials abuse their public power to extort bribes from the private agents. In both types of interaction with the public sector, the private agents are bound to face uncertainty with respect to their disposable incomes. To analyse effects of this uncertainty, a stochastic dynamic growth model with the public sector is examined. It is shown that deterministic excessive red tape and corruption deteriorate the growth potential through income redistribution and public sector inefficiencies. Most importantly, it is demonstrated that the increase in corruption via higher uncertainty exerts adverse effects on capital accumulation, thus leading to lower growth rates.
Noise trading in small markets
- Palomino
Speculation duopoly with agreement to disagree
- Kyle