Interaction of voluntary disclosure and earnings management

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Gerald Harrell
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1 Interaction of voluntary disclosure and earnings management A theoretical perspective

2 2 ways to think about it How does voluntary disclosure affect/is affected by earnings management in mandatory reports? Do firms manage voluntary disclosures (such as earnings forecasts)? And, if so, how?

3 Modeling tools A simple model of earnings management (mandatory reports) Voluntary disclosure: the unraveling result how to overcome it Putting it together

4 Earnings Management A simple model max P( Ω) r - C(r,x) r -1 - r 2 1 x 2 Stock price Cost of earnings management FOC: 1 ( r x ) = 0 r(x) x 1 P(r) E[x ~ r] r -1 r: reported earnings x: true earnings true value of the firm is x

5 Earnings Management A simple model: Truthful reporting in equilibrium max P( Ω) - r C(r,x) r -1-2 r x Stock price Cost of earnings management r(x) x P(r) E[x ~ r] r r: reported earnings x: true earnings true value of the firm is x

6 Earnings Management A simple model: What are C(r,x)? Cost of discretionary accruals? Reputation? Litigation? Real earnings management costs? max P( Ω) r - C(r, x) Stock price Cost of earnings management r: reported earnings x: true earnings true value of the firm is x

7 Earnings Management A simple model: What are C(r,x)? max E [ x - C(r, x) r ] Cost of discretionary accruals? Reputation? Litigation? Real earnings management costs? Unmanaged earnings Cost of earnings management Stock price r: reported earnings x: true earnings true value of the firm is x

Litigation? Real earnings management costs?

8 Earnings Management A simple model: Loss of information max P( Ω) - r b0 1 r-1 b r C(r, x, ) r x 2 Stock price Cost of earnings management FOC: b 1 ( r x η ) = 0 r(x) b1 x 2 P(r) E[x ~ x () r] x r b μ 1 x 2 2 x r: reported earnings x: true earnings true value of the firm is x

management FOC: b 1 ( r x η ) = 0 r(x) b1 x 2 P(r) E[x ~ x () r] x r b

9 Earnings Management A simple model: Loss of information (cont.) max η* η*( b r) P( Ω) - r b0 1 Stock price - C(r,x) r 2 1 x 2 Cost of earnings management FOC: b 1 η ( r x ) = 0 r(x) b1 x 2 P(r) E[x ~ x () [ r] ] x r μ x b x 1 r: reported earnings x: true earnings true value of the firm is x

earnings management FOC: b 1 η ( r x ) = 0 r(x) b1 x 2 P(r) E[x ~ x () [

10 Earnings Management A simple model: Summary Significance of marginal costs Nature of misreporting costs Loss of information

11 Modeling tools A simple model of earnings management (mandatory reports) Voluntary disclosure: the unraveling result how to overcome it Putting it together

12 Voluntary Disclosure The unraveling result: How voluntary is voluntary disclosure? Unraveling Result Grossman (1981) Milgrom (1981) (1) Disclosures are costless Jovanovic (1982) Verrecchia (1983) (2) Investors know that firms have, in Dye (1985) fact, private information Jung/Kwon (1988) (3) Firms know how investors will interpret the disclosure (4) Managers want to maximize share price (5) Firms can credibly disclose their private information (6) Firms cannot commit ex-ante to a specific disclosure policy. Dutta/Trueman 2002 Fishman/Hagerty 2003 Einhorn (2007) Korn (2004) private information Beyer/Guttman (2012) Vives 1984 Goex/Wagenhofer 2009 Full disclosure Partial disclosure

private information Jung/Kwon (1988) (3) Firms know how investors will interpret the disclosure (4) Managers want to maximize share price (5) Firms can credibly disclose

13 Modeling tools A simple model of earnings management (mandatory reports) Voluntary disclosure: the unraveling result how to overcome it Putting it together

14 A simple model max P(r) r x r(x) x P(r) E[x ~ 1 r] r -1 r = x +1 x 45⁰ `true earnings x Report Payoff Eq. report r = x +1 x 0.5 Truthful report r = x x 1 No disclosure - 8

15 A simple model max P(r) r x r(x) x P(r) E[x ~ 1 r] r -1 r = x +1 x 45⁰ x 0 1 `true earnings x No disclosure P ND = 0.5 Report Payoff Eq. report r = x +1 x 0.5 Truthful report r = x x 1 No disclosure 0.5

16 A simple model max P(r) r x P' P (r) (r x) 0 P(r(x)) x r = x +1 x 45⁰ x 0 1 `true earnings x No disclosure P ND = 0.5 Report Payoff Eq. report r = x +1 x 0.5 Truthful report r = x x 1 No disclosure 0

17 A simple model r = x +1 x 1 x 0 EM x x 0 45⁰ `true earnings x Report Payoff Eq. report r = x +1 x 0.5 Truthful report r = x x 1 No disclosure 0

18 Voluntary Disclosure with Earnings Management A simple Model: Summary Equilibria with - Partial disclosure - Full disclosure Disclosure is a social bad - Disclosure cost Can there be a benefit to disclosure?

disclosure - Full disclosure Disclosure is a social

19 Modeling tools A simple model of earnings management (mandatory reports) Voluntary disclosure: the unraveling result how to overcome it Putting it together - Simple model - Model with real effects

20 Investment decision Myers and Majluf (1984) t=1 t=2 t=3 The owner/manager learns the value of his firm s assets in place, x. has investment opportunity that requires $I of (equity) capital and generates return µ > 0 The manager decides whether to raise capital, number of shares α offered to investors Cash flows are realized and paid out. Pursued new investment t opportunity: Investors: α(x I μ) Manager: (1 α)(x I μ) Did not pursue new investment opp. Manager: x Investors require α shares: I αe[x ~ I μ Ω] Manager prefers to invest iff: x (1 α)(x I μ)

number of shares α offered to investors Cash flows are realized and paid out.

21 Investment decision Myers and Majluf (1984) Manager s payoff Without raising capital: x When raising capital: (1-α)(x+I+µ) (1-α)(I+µ) 45⁰ Raise capital invest Do not raise capital do not invest Value of the firm s assets in place: x Inefficient: Underinvestment

22 Investment decision and disclosure decision Beyer and Guttman (2012) t=1 t=2 t=3 The owner/manager learns the value of his firm s assets in place, x. has investment opportunity that requires $I of (equity) capital and generates return µ > 0 The manager decides whether to raise capital, number of shares α offered to investors whether to voluntarily disclose information and if so what report, r, to issue. Cash flows are realized and paid out. Pursued new investment t opportunity: Investors: α(x I μ) Manager: (1 α)(x I μ) Did not pursue new investment opp. Manager: x Investors require α shares: I αe[x ~ I μ Ω] Manager prefers to invest iff: x (1 α)(x I μ)

23 Model with real effects EM Report r(x) 2.0 EM(x) 1.5 r(x) ⁰ Assets in place, x Assets in place, x

24 Model with real effects Cost of EM > µ Cost of EM < µ Disclosure No Disclosure EM(x) Disclosure Investment Assets in place, x

25 Model with real effects Cost of EM > µ Cost of EM < µ Disclosure EM(x) No Disclosure Inv. Discl. No Investment No Disclosure Investment Disclosure x D 1 Assets in place, x x D 2

26 Model with real effects Cost of EM > µ Cost of EM < µ Disclosure No Disclosure EM(x) Disclosure Investment x I Assets in place, x

27 Model with real effects Cost of EM > µ Disclosure Indifference curve Cost of EM < µ No Disclosure EM(x) Investment No Disclosure Investment Disclosure x I Assets in place, x

28 Model with real effects Cost of EM > µ Cost of EM < µ Disclosure EM(x) No Disclosure Inv. Discl. No Investment No Disclosure Investment Disclosure x D 1 Assets in place, x x D 2

29 Model with real effects Indifference curve Cost of EM > µ Cost of EM < µ Disclosure EM(x) No Disclosure Investment No Disclosure Investment Disclosure x 1 D Assets in place, x x 2 D x I

30 Model with real effects Cost of EM > µ Disclosure No Disclosure Indifference curve Cost of EM < µ EM(x) Investment No Disclosure x 1 D No Investment No Disclosure x IAssets in place, x x 2 D Investment Disclosure

31 Model with real effects Indifference curve Cost of EM > µ Cost of EM < µ Disclosure EM(x) No Disclosure Inv. ND Inv. D No Investment No Disclosure Investment Disclosure x I x D 1 Assets in place, x x D 2

32 Model with real effects Interdependence of - Decision whether to disclose and earnings management - Disclosure decision and investment decision Equilibrium i is more complex than threshold h strategy t - Disclosure decision - Investment decision

33 Future Research Some themes Earnings - Accounting standards Earnings management - Manipulation vs. Information Voluntary disclosure - Reputation Interdependencies: disclosure and - investing, financing

Incentives for risk reporting

Incentives for risk reporting a discretionary disclosure and cheap talk approach Presentation at the 30th Annual Conference of the EAA Lisbon, April 26, 2007 Dr. Michael Dobler, MBR Ludwig-Maximilians-University