Reputation Management and the Disclosure of Earnings Forecasts

Transcription

1 Reputation Management and the Disclosure of Earnings Forecasts Anne Beyer Stanford University Ronald A. Dye Northwestern University October 7, 010 Abstract In this paper, managers differ from each other in terms of the probability they are forthcoming (and disclose all the earnings forecasts they receive), or strategic (and disclose the earnings forecasts they receive only when it is in their self-interest to do so). Strategic managers choose to disclose or withhold their earnings forecasts based on both the effects of the disclosures on their firms stock price and on their reputation among investors for being forthcoming. Our findings include: strategic managers can build a reputation for being forthcoming by disclosing unfavorable forecasts that they would otherwise keep private; even though some strategic managers incentive to build a reputation for being forthcoming may be so strong that the managers disclose even the most negative forecasts they could receive, in equilibrium some other strategic managers must prefer to issue forecasts without concern for their reputation for being forthcoming; an increase in the persistence of a firm s earnings has the same effect on a strategic manager s disclosure behavior as does a (suitable) decrease in the manager s concern for developing his reputation for being forthcoming; as managers become more concerned about their reputation: (a) the current price of the firm in the event the manager makes no forecast today increases; (b) managers who have a high probability of behaving strategically in the future issue forecasts more often in the present, while (c) managers who have a high probability of behaving as forthcoming in the future issue forecasts less often in the present.

2 1 Introduction We examine how managers can affect both their reputations in capital markets and the market values of the firms they manage by disclosing forecasts of their firms future performance. Two effects of managers disclosure of forecasts are well known and well understood. First, the disclosures affect firms market values (see, e.g., Pownall and Waymire 1989; Pownall, Wasley and Waymire 1993). And second, managers work hard to ensure that, after they issue a forecast, their firms actual performance lives up to the forecast (see, e.g., Kasznik 1999; Soffer, Thiagarajan and Walther 000). What is less well understood and what we study in this paper is how managers propensity to issue forecasts affects and is affected by their reputation for disclosing value-relevant information in a timely manner and, more generally, for being known as forthcoming. Survey evidence suggests that managers believe making voluntary disclosures enhances their reputations with investors. For example, Graham et al. (005) s survey of financial reporting finds that more than 9% of the managers surveyed agreed with the statement that: Voluntarily communicating financial information [...] promotes a reputation for transparent/accurate reporting. In addition, some financial reporting experts believe that, by developing a reputation for being forthcoming, managers enhance their firms market values. For example, Miller and Bahnson (00), in their book on financial reporting, state that: We think that establishing a pattern and reputation for being forthcoming, honest, and timely will boost stock prices and cut capital costs, simply because these actions will reduce uncertainty and risk for capital market participants. Notwithstanding this survey evidence and expert opinion, it is not clear that managers concern for being known as forthcoming is always salutary, because: (a) a manager known for being forthcoming may be able to exploit his reputation and withhold negative news from the capital markets, and (b) while a manager can improve his reputation for being forthcoming by disclosing negative information about his firm, this improvement in his reputation can come at the cost of reducing his firm s current market value. In this paper, we identify some of the consequences of managers concerns for being known as forthcoming, and we develop predictions about managers disclosure of forecasts in the presence of these reputation-related concerns that are amenable to empirical testing. We do this by constructing a model where managers concern about their reputation for being known as forthcoming influences their disclosure practices as well as investors interpretations of firms forecasts (or their absence). 1

3 The model we develop contains what we regard as the minimal ingredients for such a study: it is a two period model (today/the future) where, in each period, every firm s manager probabilistically receives an advanced forecast of his firm s earnings for the period, which the manager can either disclose to investors or withhold. The manager is concerned about maximizing a weighted average of his firm s current and future prices. 1 Managers potentially differ from each other in the probability they behave either as forthcoming or strategic in each period, where a forthcoming manager discloses his earnings forecast whenever he receives it and a strategic manager discloses his forecast only if it is in his self-interest to do so. knows his own type (i.e., his probability of behaving strategically in a period). Each manager And, while investors do not know any manager s type, they update their beliefs about a manager s type based on whatever forecasts the manager does or does not issue. Strategic managers anticipate how the disclosure of their earnings forecasts affects their reputation for being forthcoming, and the reputations strategic managers develop affect their incentives to issue earnings forecasts. The equilibrium of the model yields a variety of predictions. A key to many of these predictions is that a strategic manager can build his reputation for being forthcoming by disclosing an unfavorable earnings forecast today. While the immediate effect of disclosing such an unfavorable earnings forecast is to reduce the firm s current market value, such a disclosure increases the expected value of the firm in the future by increasing the firm s future no disclosure price. The latter effect obtains because investors revise their perceptions of the probability the manager is forthcoming upwards when the manager discloses an unfavorable forecast today, which leads investors to conclude that any nondisclosure in the future is more likely attributable to the manager not having received information rather than to the manager having deliberately withheld information. One equilibrium prediction of the model is that managers who are more likely to behave strategically in the future have a greater incentive to issue a forecast today (than do managers who are less likely to behave strategically in the future) because such managers obtain greater expected benefits from being perceived as forthcoming in the future. Further, we show that this reputational effect can be so strong that some strategic managers may disclose today the very worst earnings forecast they could possibly receive. This prediction stands in contrast to the predictions of one-period models of voluntary disclosure in the existing literature, where managers never disclose the worst information they could possibly receive, considerations are necessarily absent in such one period models. because reputational This last prediction that reputational forces can be so strong as to induce some managers to disclose the worst information they could receive merits contrast with another prediction of the model: in equilibrium, a large fraction of strategic managers must not engage in reputation management, i.e., some strategic 1 If the manager s objective function were only to maximize his firm s price at one point in time either the present or the future, for example it is easy to show that there is no possibility of reputation formation. When there is a positive probability that the firm does not receive information during the period.

4 managers must ignore the effects of their disclosures today on their future reputations. 3 this result is as follows: The intuition for were investors to conjecture that all strategic managers invest in building their reputations by disclosing some unfavorable earnings forecasts today, then investors posterior beliefs about the probability the managers were strategic (after observing these unfavorable forecasts) would be the same as investors prior beliefs (before observing the forecasts). 4 But, if managers think investors won t change their beliefs of the managers types in response to observing such unfavorable forecasts, then the downside for the managers of disclosing those negative forecasts (a lower current period stock price) won t be offset by an upside of disclosing those negative forecasts (investors perceiving the managers as more likely to be forthcoming). Thus, managers actual disclosure behavior will not conform to investors conjectures about their behavior, and hence those conjectures cannot be part of an equilibrium. Therefore in any equilibrium, some managers must be better off not engaging in reputation management by disclosing unfavorable forecasts. We also show that as a manager s incentives for developing a reputation increase which we operationalize by supposing that the manager puts more weight on his firm s future stock price relative to its current stock price then the firm s current price in the event the manager does not issue a forecast today increases. This follows because nondisclosure today is less likely to be due to the manager having withheld information, and more likely due to the manager not having received information, as the importance of acquiring a reputation increases. Also, we show that managers who have a high probability of being strategic in the future issue forecasts more often today as their concern for their reputation increases, whereas managers who have a low probability of being strategic in the future issue forecasts less often today as their concern for reputation increases. We also generate predictions about the effects of changing the persistence a firm s earnings on its manager s propensity to issue earnings forecasts. Among other things, we show that, when a firm is run by a strategic manager today, the effect of increasing the persistence of the firm s earnings on its manager s current disclosure policy is indistinguishable from the effect of (suitably) reducing the manager s concern for developing his reputation for being forthcoming. This result is intuitive: as the persistence of a firm s earnings increases, the value relevance of its current earnings forecast for the firm s future market value increases relative to its future earnings forecast, which in turn diminishes the importance its manager will attach to developing a reputation for being forthcoming in the future. In addition, we show that an increase in the volatility of the firm s future earnings has the opposite effect of an increase in earnings persistence: as the volatility of future earnings increases, the value relevance of future earnings forecasts for the firm s future market value increases (relative to the current earnings forecast), which has the effect of amplifying the importance the firm s manager will attach to developing a reputation for being forthcoming in the future. 3 In fact, we will show that, in our model, that at least 50% of all managers do not engage in reputation management. 4 For a formal argument that shows why investors will not change their beliefs about a manager s type were investors to believe that all strategic managers disclosed the same unfavorable forecast, see footnote 3. 3

5 Additional predictions of the model are deferred to the body of the paper. Related Literature The foundational models of voluntary disclosure of Grossman (1981) and Milgrom (1981) demonstrate that, in a market where: 1. sellers know the attributes of the product they are selling;. buyers know that all sellers select their disclosure policies so as to maximize their firm s expected market value; 5 3. buyers know the range of potential attributes of the sellers products; 4. all buyers evaluate products in the same way; 5. antifraud rules prevent sellers from making false claims about their products; and 6. the attributes of the product being sold can be ordered in terms of the product s quality or value, then the market unravels in equilibrium in the sense that every seller will fully disclose the attributes of the product he sells so as to distinguish his product from other lower quality products. Grossman and Milgrom s full disclosure result generated many subsequent extensions and modifications, including the observation that unravelling would not obtain in equilibrium under conditions -6 above if: condition 1 were replaced by: 7. sellers occasionally are uninformed about the value of their products, and 8. when a seller makes no disclosure, buyers cannot discern whether the reason the seller made no disclosure was that he did not have information or was withholding information (cf., Dye 1985 and Jung and Kwon 1988). The model in the present paper can be viewed as extending Dye (1985) and Jung and Kwon (1988) to a multi-period context where conditions 3-8 above hold and condition is replaced by the assumption that managers objective functions are not perfectly known to investors (in particular, investors do not know with certainty whether any given manager is strategic or forthcoming). In addition to building on the Grossman-Milgrom models, the present paper also shares two features common to many economic models of reputation (e.g., Kreps and Wilson 198; Milgrom and Roberts 198; Kreps, Milgrom, Roberts and Wilson 198; and Fudenberg and Kreps 1987). First, often the most natural formulation of the model does not possess an equilibrium in pure strategies, i.e., where the decisions of strategic players are always deterministic. This is true of the version of our model which contains only two types of managers managers who are always forthcoming and disclose any information they receive, and managers who are always strategic and disclose their private information only if it is in their self-interest to do so. 6 This lack of an equilibrium is both a substantive problem and a technical problem. It is a substantive 5 This is the adaptation of the objective function of the Grossman and Milgrom models to a capital market context; in a product market context, the objective function Grossman and Milgrom actually adopt is slightly different from the preceding. 6 The intuition is as follows. If an equilibrium did exist with deterministic disclosure policies when the private information a manager receives is continuously distributed, then a strategic manager s optimal disclosure strategy in each period is necessarily described by a cutoff, with the manager preferring to disclose or withhold the private information he receives depending on whether that information is above or below the cutoff. Notice that were a strategic manager who received information just below the hypothesized first period cutoff to disclose his information contrary to its expected equilibrium behavior then the manager would obtain a discrete increase in his expected utility since: (a) investors only expect forthcoming managers to disclose information below the cutoff, investors would (incorrectly) infer that the manager was forthcoming with certainty and (b) other things equal, a strategic manager is always strictly better off by raising investors perceptions of the probability that he is forthcoming. Since this inconsistency between managers conjectured and actual behavior occurs no matter where the equilibrium cutoff is posited to be located, it follows that no equilibrium in deterministic disclosure strategies can exist. (This 4

6 problem insofar the nonexistence of an equilibrium thwarts our goal of developing a model that generates predictions as a model without an equilibrium has no predictions. But it is also merely a technical problem insofar as the nonexistence problem arises principally because, in the most natural economic formulation of the problem, the information content of minute changes in reported earnings is artificially exaggerated (for reasons discussed in the preceding footnote). In this paper, we show that this technical nonexistence problem can be resolved in a natural way by redefining a manager s type as the probability that the manager behaves strategically in a period. The second feature the present paper shares with many economic models of reputation is that multiperiod considerations alone are not sufficient for reputation formation: reputations can form and evolve only when managers (or, more generally, individuals concerned about developing a reputation) differ in some relevant unobservable exogenous characteristics such as in their objective functions. Investors (or, more generally, whoever is concerned about evaluating the individuals) update their inferences about the managers exogenous characteristic over time by observing the managers behavior, and managers adjust their behavior so as to influence investors inferences about the characteristic. While in our model the exogenous characteristic is the probability that managers are strategic or forthcoming, in other settings the exogenous characteristic could be, for example, the propensity of incumbent firms in an industry to respond rationally to market entry by rival firms, or the propensity of one country s government leaders to react sensibly to provocations by neighboring states, etc. The present paper is also related to the existing models of disclosure that address reputation-related concerns (e.g., Sobel 1985; Benabou and Laroque 199; Stocken 000; Morris 001). As far as we are aware, all such extant models involve cheap talk. There are at least three key differences between our model and the extant cheap talk models of disclosure. First, the extant cheap talk models of voluntary disclosure address the issue of building a reputation for making truthful disclosures whereas our model addresses the issue of building a reputation for being forthcoming and disclosingprivateinformationinatimelymanner. Second, in cheap talk models, by definition, there need be no connection between what managers say and what they know to be true. This is unlike our model and other models of disclosure that build on the Grossman-Milgrom framework where, though disclosures can be selective, anti-fraud rules are assumed to be sufficiently strong so that all disclosures are confined to be truthful. Cheap talk models necessarily disregard the sizeable civil and/or criminal penalties that can be imposed on managers and/or their firms when they are caught making false statements to financial markets, clearly a relevant issue in studying models of financial reporting. Third, the extant cheap talk models all involve reports about the realization of binary-valued random variables (e.g., Sobel 1985; Benabou and Laroque 199; Stocken 000; Morris 001). Disclosures of binary-valued random variables are inherently incapable of displaying much richness in the possible range informal argument is more formally developed in a working paper version of the manuscript.) 5

7 of firms disclosure policies, and hence are incapable of saying much about actual firms propensity to make disclosures about the vast array of private information they have. The seminal truthful disclosure models of Grossman (1981) and Milgrom (1981) spawned a variety of innovations in the theoretical literature on voluntary disclosures in accounting and economics, but none of those innovations has addressed reputational or multi-period issues. Given the importance of the Grossman- Milgrom all disclosures must be truthful framework to this literature, and the practical importance of reputations in the financial reporting process, an important gap in the literature remains to be filled: a model that marries the Grossman-Milgrom framework to a multi-period setting where management reputations are important. Our model starts to fill that gap, by studying the selective, but truthful, disclosure of information over time that allows managers to build a reputation for disclosing their private information in a timely manner. The paper proceeds as follows. model and section 4 characterizes the equilibrium of the model. paper. Section introduces the model. Section 3 defines the equilibrium of the Section 6 concludes. The appendix contains the proofs of the main results. Model Setup Section 5 contains the main results of the This section presents a two period model where, in each period, a firm s manager occasionally privately receives advanced information about the firm s forecasted earnings for that period before a market for the firm s shares opens. The manager chooses to disclose or withhold his forecast depending on whether the disclosure increases the expected value of the weighted average of the firm s stock price: [ e 1 +(1 ) e ] (1) where is the firm s stock price in period and (0 1) is some exogenous constant determining the relative weight the manager places on the firm s first and second period prices. 7 The firm s period forecast is denoted by, the realization of the random variable. 1 is taken to be uniformly distributed on [ 1 1] while conditional on 1 is taken to be uniformly distributed on 7 Other papers have used similar objective functions. See, e.g., Miller and Rock (1985) and Harris and Raviv (1985). It should also be noted that this objective function of the manager could be replaced by the objective function: maximize the expected value of: ( 1 )+ 1 ( 1 1 )+ 3 ( 1 1 )+ 4 ( 1 1 ) for coefficients where: 0 is the price of the firm at the start of the model; 1 ( 1 ) is the price of the firm at the time a disclosure (or nondisclosure) is made in period 1; 1 ( 1 1 ) is the price of the firm at the end of period 1 after 1 is disclosed (whether or not it was disclosed previously); and similarly for ( 1 1 ) and ( 1 1 ) Replacing the stated objective function with this alternative would yield results identical to the results of the model in the paper when the coefficient of 1 ( 1 ) in our model is set equal to 1 ( ) and the coefficient 1 of ( 1 1 ) is set equal to 3 ( ). This is true because, as will be clear below from the assumptions we make about 1 and, 0 0, 1 ( 1 1 ) (1 + 1 ) 1 and ( 1 1 ) regardless of what disclosure policy the manager adopts, and so all that matters as far as characterizing the manager s preferred disclosure policy is concerned is the weight the manager places on the first period price 1 ( 1 ) relative to the weight he places on the second period price ( 1 1 ).Inotherwords, whileinthecurrentversionofthemodelwesetthecoefficients 0 = = 4 =0, we could have set those coefficients at any other values without affecting any of our results. 6

8 [ ] where 0 0 and The density and distribution function of 1 (resp., given 1 ) are denoted by 1 ( 1 ) and 1 ( 1 ) (resp., ( 1 ) and ( 1 )). This formulation encompasses cases in which earnings: are iid across periods ( 0 =1, 1 =0); follow a random walk ( 1 =1); or exhibit negative auto-correlation ( 1 0). At the end of each period, the firm s earnings are distributed to shareholders as a dividend. 9 Firms are priced at the expected value of their future earnings where the future is, for convenience, not discounted. These assumptions ensure that the expected price of the firm at the start of the first period is [ 1 + ]= [ 1 + [ 1 ]] = [(1 + 1 ) 1 ]=0and the expected price of the firm at the start of the second period, after 1 becomes known, is [ 1 = 1 ]= 1 1. The event that the manager receives a forecast in a period occurs with constant probability and is independent from one period to the next. In conformity with the existing disclosure literature, we assume that, in all cases: (1) if the manager does not receive a forecast during a period, the manager necessarily makes no disclosure, 10 and () if the manager receives a forecast, he can either issue the forecast or disclose nothing. 11 We posit that a manager s disclosure decision may be constrained, insofar as in some periods he may be obliged to disclose whatever information he receives, whereas in other periods he may be unconstrained, in which case his disclosure decision is determined entirely by whether the disclosure maximizes the objective function (1) above. We refer to situations in which the manager is constrained by saying that the manager behaves as forthcoming. 1 We presume that the probability that the manager is forthcoming in a period is the same and independently distributed across both periods. say that he behaves strategically. When the manager is not constrained, we To motivate the potential fluctuations in the manager s behavior described above from constrained in one period to possibly unconstrained in another period (or vice versa) we note that even if all managers are inherently opportunistic and bent on disclosing information only when they obtain some advantage by doing so, there may be factors that prevent an opportunistic manager from acting strategically in a 8 The assumption that realized earnings can be negative is adopted merely to simplify some subsequent notation by allowing the mean of the first period earnings to be set equal to zero. While these negative earnings can be interpreted literally (as losses), they can alternatively be interpreted as simply left-shifted translations (in the mathematical sense) of positive earnings; all propositions in the paper could be restated so that all earnings are nonnegative by shifting the distribution of earnings to the right without affecting the substance of the propositions. Similar remarks hold for negative prices. 9 This assumption can be dropped without affecting the substance of any results that follow. 10 In this literature (see, e.g., Dye 1985 and Jung and Kwon 1988), managers are presumed not to be able to credibly disclose that they did not receive information (under the presumption that it is difficult, if not impossible, for the managers to prove a negative, viz., that they did not receive information). 11 That is, defalcations or incomplete disclosures of information are not entertained. Defalcations are ruled out by the implicit assumption, also common in this literature, that anti-fraud rules are sufficiently stringent, and enforced with a sufficiently high probability, so as to make manipulating information unattractive. Partial disclosure of the manager s private information is ruled out by the results of Grossman (1981) and Milgrom (1981), who observed that firms will be obliged to disclose completely any information investors know they have so as to distinguish themselves from other firms who have less favorable information. 1 An alternative way of motivating the situation a constrained manager finds himself in is that he is preempted: if the manager does not disclose the information, the information will be revealed by sources external to the firm. When a manager anticipates he might be preempted, the manager is better off disclosing the information himself, rather than have it revealed by other parties, as revealing the information himself improves investors assessment of the probability the manager is forthcoming. 7

9 particular period in which case he behaves as forthcoming. For example, in some periods, the effectiveness of the firm s internal controls, or the scrutiny by the firm s auditors, or by outside news organizations, may be sufficiently good or sufficiently detailed that a manager loses the ability to control the disclosure of his private information. In that case, the manager may be obliged to behave as though he is forthcoming and issue a timely forecast that he might otherwise prefer to remain hidden. In other periods, the firm s internal controls may be more lax, its auditors may be less vigilant, the news organizations that follow the firm may be less alert, etc. In that case, the manager may have the opportunity to behave strategically and decide whether to issue a timely forecast depending on the effect of that disclosure on (1). Moreover, the firm s auditors are likely to be the same over time, the reliability of the firm s system of internal controls is likely to be constant over time, the quality of news organizations scrutiny of the firm may be stationary over time, etc. Hence, the probability that an (inherently opportunistic) manager may be able to act strategically and discretionarily disclose or withhold his information may be constant over time, consistent with the assumption underlying the model that the probability a given manager behaves strategically is time-stationary. 13 We let the random variable reflect the probability the manager is strategic or unconstrained in each period. For a given manager, the realization of is fixed across time. is also taken to be independent of all other variables in the model, and distributed uniformly on [ + ] [0 1] where the parameters and are common knowledge. 14 The prior density of is denoted by (). Atthestartofthemodel,every manager privately learns the realization of his. Capital market participants know the ex ante distribution of, but not its realization for any manager. They make inferences about overtimebasedonamanager s observed disclosure behavior. The capital market s perceptions of at a point in time defines the manager s reputation at that time. A manager s reputation will vary over time, depending on whether the manager issues a forecast, and if so, what forecast, during the period. The manager s reputation also varies depending on the realized value of the firm s earnings. As will soon be clear, the updating process that describes how the manager s reputation evolves over time is quite complicated. These complications are simplified slightly by having the manager s forecast be accurate, i.e., by having the realized value of the firm s earnings coincide with the forecasted value of those earnings. Said in other words, the model can be viewed as one where the manager develops a reputation for the timely disclosure of his forecast (with untimely forecasts being made after the market for the firm s shares closes at the end of a period). This situation arises often in accounting: for instance, managers might learn that the firm s assets are impaired early in a period and might either disclose this information voluntarily during the period or wait 13 Some other models of reputation in economics have adopted similar assumptions. For example, Wiseman (008) posits that firms behavior over time may also be as he describes it impermanent, in that in his model of a chain store game, the incumbent firm s type evolves according to a Markov process with two states, a tough state/type that always fights entry by potential rivals and a weak state/type that prefers to accommodate potential rivals entry. 14 For a similar distributional assumption, see Milgrom and Roberts (198). 8

10 untilitisrevealedinthefirm s periodic financial statements. As another example, for a supplier whose primary business is to fill the periodic orders of a single major customer, the bulk of the uncertainty about its future earnings is resolved when the firm learns the details about that customer s orders. But, whether the supplier learns, or discloses, information about the customer s orders during a quarter or not, the company is obliged to report its quarterly earnings subsequently in order to be in compliance with the SEC s mandatory filing procedures. As a third example, a manager who receives private information about the success of certain projects such as FDA approval for an experimental drug may choose to disclose or withhold that information. But, whether or not he receives such advanced information, it eventually becomes public knowledge either because the information appears in the firm s financial statements or because it is disclosed through other information channels. Many other examples like this occur in practice where a manager s opportunity to selectively disclose information is followed by the eventual required or certain release of the information. To complete the description of the model, we introduce the random variables, =1 to denote whether the manager behaves strategically or as forthcoming in period, with =1(resp., =0) indicating that the manager behaves strategically (resp., forthcoming). Given the preceding specifications, Pr( =1 ) = for =1 and 1 and are independent, conditional on At the start of period 1, in addition to knowing the realization of, the manager learns the realization of 1, but not the realization of.helearns the realization of only in period, under the premise that while a manager may be able to predict the probability he will be unconstrained in the future, he cannot know for certain whether he will actually be unconstrained in the future until the future arrives and he learns the specific circumstances he finds himself in then. Finally, we denote the manager s period forecast decision generically by. If the manager issues the forecast,wewrite = If the manager does not issue a forecast in period, we write either = or (the shorthand). Thesequenceofeventsissummarizedinthefollowingfigure. Figure 1: Timeline 3 Definition of Equilibrium To define the equilibrium formally, let =1or 0 depending on whether the manager does ( =1)ordoes not ( =0) receive information in period. By using this convention, we can write the period 1 disclosure policy when = as the function 1( ) regardless of whether the manager does or does not learn 1 9

11 in period 1, with the stipulation that if the manager does not receive information in period 1 he does not issue a forecast, i.e., 1( 1 =0 1 1 ). Likewise, we can write the manager s period disclosure policy as ( 1 1 ) with the stipulation that ( =0 1 1 ). Definition 1 An equilibrium consists of a pair of disclosure policies 1 ( ) and ( ) for each [ + ] and pricing functions 1 ( ) and ( ) such that: A. for each [ + ]: a1. 1( 1 =0 1 1 ) and ( =0 1 1 ) ; a. 1( 1 =1 1 =0 1 ) 1 and ( =1 =0 1 1 ) ; a3. a4. ( =1 =1 1 1 ) arg max ( 1 1 ); { } 1( 1 =1 1 =1 1 ) arg max 1 ( 1 )+(1 ) 1 1 ( 1 1 ) 1 ; 1 { 1} and B. for each 1 1 and : 1 ( 1 ) = h i e 1 + e 1 ( )= 1 ( 1 1 ) = h i e 1 1 ( 1 1 )=. The formal definition of equilibrium is straightforward: (a1) requires that if managers get no information, they necessarily do not issue a forecast. (a) requires that managers who are forthcoming in a period issue a forecast whenever they receive information. (a3) requires that when = and a manager is strategic in period, the manager issues a forecast in period provided he gets a higher price from issuing the forecast than from withholding it, taking the period pricing function as given. (a4) requires that when = and a manager is strategic in period 1, the manager issues a forecast in period 1 provided he gets a higher expected weighted average price over the two periods from issuing the forecast than from withholding it, taking the pricing functions of both periods as given. (B) requires that, taking managers forecasting policies as given, in each period investors price the firm at the expected value of the firm s future earnings taking into account all current and past forecasts and earnings reports the manager has issued, and the information those forecasts and reports reveal about,,and. To characterize the equilibrium, we proceed backwards in time by first deriving the manager s equilibrium disclosure policy in period. Since period is the last period in the model, the manager faces no reputational concerns then, and the manager s disclosure policy can be found using a process analogous to that used to identify the equilibrium disclosure policies in single period settings (see Dye 1985; and Jung and Kwon 1988). This is outlined in the following two-step process. 10

12 Step 1. We observe that a manager who is strategic in period adopts a cutoff disclosure policy defined by the second period no disclosure price. Such a manager discloses the forecast (when received) if and only if = ( 1 1 = ) ( 1 1 = ) = () Consequently, if 1 denotes investors assessment of the probability that the manager is strategic as of the start of the second period given his disclosure of 1 in the first period, 15 then investors assessment of the probability a manager will not issue a forecast in the second period is ( 1 ) This is the sum of the probability 1 the manager does not receive a forecast and the probability 1 ( 1) the manager receives a forecast, is strategic, and chooses to withhold his forecast. Using Bayes rule, it follows that investors assess the firm s expected second period earnings, given that the manager does not issue a second period forecast, to be: (1 )[ 1 ]+ 1 ( 1 )[ 1 ] ( (3) 1) These earnings are a weighted average of (1) the unconditional expected value of the firm s earnings, [ 1 ] (applicable when the reason the manager did not issue a second period forecast is that he did not receive information), and () the conditional expected value of the firm s earnings, [ 1 ] (applicable when the manager received a forecast, was strategic, and deliberately withheld his information). The weight attached to the first (resp., second) of these expectations is determined by the posterior probability that the manager did not receive information (resp., did receive information, was strategic, and withheld information), given that the manager issued no second period forecast. Step. The second period no disclosure price in equilibrium also equals the expected value of the firm s earnings given no forecast, i.e., equals (3). Solving the quadratic equation that results from equating with (3), and selecting the only root that belongs to the support of (i.e., inside [ ]), yields the second period disclosure threshold ( 1 1 )= : = ( 1 1 )= 1 1 ³ 0 (1 )+ 1 p (1 )(1 + 1 ) (4) 1 The preceding characterizes a strategic manager s second period equilibrium disclosure policy, once investors assessment of the probability 1 that the manager will behave strategically as of the start of the second period is known. But, of course, 1 is endogenous and depends on the manager s first period disclosure policy, which is also endogenous and has yet to be determined. 15 This is explained by the fact that =1(resp., =0) when the manager is strategic (resp., forthcoming) and [ ] =, so investors perceptions of the probability that a manager will behave strategically in period, given 1 and 1,issimply: [ 1 1 ]=[[ ] 1 1 ]=[ 1 1 ] 1 11

13 In the next section, we show that a strategic manager s first period equilibrium disclosure policy can also be described as a cutoff policy, in this case by a function 1 = 1 () such that a strategic manager of type discloses 1 when he knows it (i.e., 1( 1 =1 1 =1 1 )= 1 )iff 1 1 (). Both for the purpose of constructing the function 1 (), and for other expositional purposes, it is helpful to describe a strategic manager s disclosure policy in terms of 1 () 0 inverse, 16 that is, by a threshold probability ( 1 ) such that a strategic manager of type who learns 1 = 1 in the first period discloses 1 iff ( 1 ). Disclosure policies described in this last way are said to be right-tailed at 1. 4 Characterization of the Equilibrium In characterizing the full equilibrium of the two period model, it is helpful to start by considering the manager s first period disclosure problem in more detail. only if he receives an earnings forecast and is unconstrained then. A manager faces a first period disclosure decision In that situation, when the manager learns the forecast 1 = 1, he must make conjectures about both the firm s first period price 1 ( 1 ) and its second period expected price [ ( 1 1 e ) 1 ] were he to issue a forecast ( 1 = 1 )ornotissuea forecast ( 1 = ), respectively, in the first period. When making the conjecture about the second period expected price, the manager must take into account investors perception of the probability that he will act strategically in period given his first period disclosure decision and his private knowledge that he will behave strategically in the second period with probability. The manager then chooses to disclose his private information if disclosing it leads to a higher value for his objective function (1) than withholding it. Every manager in the first period who receives information and is unconstrained makes a similar comparison. In particular, a manager who learns 1 = 1 may nevertheless disclose his information even if the resulting price, (1 + 1 ) 1,isbelowthenodisclosureprice 1 () iftheincreaseinthefirm s expected second period market value (arising from the manager s improved reputation with investors for being forthcoming) exceeds the amount he loses in the first period (1 + 1 ) 1 1 (), adjusted for the manager s inter-temporal preference parameter. The outcome of this cost-benefit analysis sorts managers into those who issue earnings forecasts and those who don t, and it also implicitly determines the expected value of the earnings of all firms whose managers choose not to issue an earnings forecast in the first period. It is intuitively clear that the manager s benefit to, or loss from, issuing a forecast in the first period in terms of the firm s expected second period price will vary cross-sectionally with the probability the manager will be able to exploit his reputation (i.e., the probability he will be unconstrained) in the second period. Understanding in detail this cross-sectional variation is key to identifying and characterizing the equilibrium of the model. To obtain that understanding, we introduce the function () that measures the amount a 16 As we discuss in additional detail in the appendix, in those instances where 1 () is flat and hence its inverse is not unique it makes no difference as to how the inverse is defined as long as the boundary separating the disclosure and no disclosure sets is correctly specified. 1

14 strategic manager anticipates losing in terms of the firm s expected second period price by withholding vs. disclosing his information. Specifically, for a given right-tailed disclosure policy ( 1 ), the function () is defined as follows: 17 ³ () h 1 1 e i ³ ( 1 )= h 1 = 1 e i ( 1 )= (5) Lemma 4 in the appendix shows that the function () is nonpositive and decreasing in. 18 That ( ) is nonpositive implies that for all types of managers, the firm s expected second period price (calculated at the end of the first period) is always at least weakly higher when the manager discloses his first period forecast than when he makes no disclosure in the first period. That ( ) is decreasing in implies that the magnitude of the difference in these expected prices increases as the probability the manager will be unconstrained and able to exploit his reputation in the second period grows. The main result of this section is the following proposition. It describes an equilibrium of this model of reputation and disclosure. Proposition 1 There is an equilibrium in which both the first and second period disclosure policies are cutoff policies, and the first and second period disclosure cutoffs and first and second period prices are specified in (1) (4) below. (1) The first period cutoff 1 () is given by: 1 () = 1 ( 1 ) 1+ 1 if 1 ( 1 )+ 1 () 1+ 1 if b 1 if b + (6) where: r (1 )+ 1 (1 )(1 + 1 )+ 1 1 R 8(1+ 1 ) () 1 ( 1 )= (1 + 1 ) ; 1 (7) and: is that unique ( + ) that solves the equation ( 3) +( +)( ) =0; ³ o b min n 1 1 ( ( 1 )) + ; 1 ( ) 4 ; () thesecondperiodcutoff ( 1 1 ) is given by: ( 1 1 ) e 1 1 1, where: 17 N.B. Even thought the notation in (5) might suggest that () depends on both 1 and, we show in the Appendix that () is in fact independent of 1 (see Lemma 4). 18 Technically, () is strictly decreasing in for all, where is defined in the statement of Proposition 1 below. The specification of () for is unnecessary for the characterization of the equilibrium. 13

15 a. ( ) is defined as in equation (4) above; b. investors perceptions of the expected value of the manager s type at the end of the first period, after observing the disclosure 1, is given by 1 = e 1 1,where: e 1 = 1 1 = e 1 = 1 = 3 (3 + ) 3(1 ) if 1 1 ( + ) 1 ( ( 1 ) 3 ( ) 3 ) 1 3( ( 1 ) ( ) ) if 1 ( + ) 1 1 () = 1 ( ) ; if 1 ( ) 1 3(1 )+(3 + ) 3(1 )+3 if 1 1 ( + ) if 1 ( + ) 1 1 () = 1 ( ) ; if 1 ( ) 1 1(1 )+( ( 1) 3 ( ) 3 ) 1(1 )+3( ( 1) ( ) ) (3) when the manager issues the forecast 1 = 1 (resp., issues no forecast) in period 1, the first period price of the firm is given by 1 ( e 1 = 1 )=(1+ 1 ) 1 (resp., 1 ( 1 )); (4) when the manager issues the forecast = (resp., issues no forecast) in period after having issued the forecast 1 = 1 (or 1 = ) inthefirst period and 1 = 1, the second period price of the firm is ( e = 1 1 )= (resp., ( e = 1 1 )= ( 1 1 )). Some comments regarding Proposition 1 follow. Part 1 is the heart of the proposition. It describes the first period disclosure policy of a strategic manager who has probability of being strategic in the second period: such a manager discloses the earnings forecast 1 in the first period (when received) iff it is above 1 () in (6). Since 1 () is weakly decreasing everywhere, and strictly so for b (since () is strictly decreasing in for ), (6) shows that the equilibrium first period disclosure policy has the intuitive feature that if the earnings forecast 1 is disclosed (when received) by a strategic manager in the first period who has probability of being strategic in the second period, then every earnings forecast is disclosed (when received) by every strategic manager in the first period who has probability 0 of being strategic in the second period. That is, a manager who is strategic in the first period is more likely to disclose his forecast in the first period the greater he perceives the probability he will behave strategically in the second period, and also the higher the value of his first period earnings forecast. Both of these results are intuitive: high first period earnings forecasts are naturally more likely to be disclosed by any strategic manager than are low earnings forecasts and, as the probability increases that a manager has the opportunity to strategically withhold forecasts in the future, a strategic manager is more likely to behave in a forthcoming fashion now, so as to favorably affect investors perceptions of his future (absence of) disclosures. To obtain this favorable effect, the manager uses the only instrument he has available now (in the first period): issue the earnings forecast he receives. The manager s first period earnings forecast favorably affects investors perceptions of his future nondisclosures because investors know 14

16 that the probability a manager behaves strategically is consistent/stationary across time. By disclosing his first period earnings forecast, the manager increases investors beliefs that he is not acting strategically when he does not issue a forecast in the second period and thereby increases the firm s price in the event he does not issue a forecast in the second period. This result demonstrates the impact of how a manager s concerns about his reputation in the future affect his current disclosure decisions. Part 1 also establishes that the first period no disclosure price 1 ( 1 ) is given by equation (7). that, in many respects, 1 ( 1 ) is similar to the second period no disclosure price in (4). For example, just as it is clear from equation (4) that the second period no disclosure price depends on both the probability the firm receives information during the second period and investors perceptions of the probability the manager will behave strategically in the second period, equation (7) shows that the first period no disclosure price also depends on the probability the manager receives information during the first period and investors perceptions of the probability the manager will behave strategically in the first period. Note Another indication of the parallels between (7) and (4) is that, absent reputational concerns (i.e., as 1), the first period and second period no disclosure prices are equivalent when 1 is replaced by and 3. Discussion of the variables and b is deferred to the next section; there they are illustrated in Figures Part of the proposition establishes, as was initially discussed at the end of the previous section, that the second period cutoff e 1 1 is given by (4). The new feature added is part b which provides explicit expressions for investors perceptions of the probability the manager will behave strategically in the second period, conditional on the manager s first period forecast and on the first period s realized earnings. Part a and b can be combined to demonstrate e 1 = 1 e 1 = 1 This is a formal demonstration of the intuitive result that in equilibrium a manager can always improve his reputation for being forthcoming i.e., increase investors perceptions of the probability that he will be forthcoming in the second period by issuing a forecast in the first period rather than by not issuing a forecast in the first period. Parts 3 and 4 provide details about the equilibrium first and second period prices. The principal point to note here is that the manager s first period disclosure decision affects his firm s second period price through affects investors interpretation of the probability the manager is strategic in the second period. Anticipation of this last effect induces some strategic managers to manage their reputation in the first period. 19 To see that 1 = ( ) reverts to as approaches 1 note that evaluated for 1 yields 4 lim 1 min 1 1 ( ( 1 )) + = +. Consequently, 1 = (+) ( ) =. 4 0 The term 1 in part 1 equals (); it is the truncated probability the worst possible first period forecast 1 = 1 is withheld when received. 15

17 In a working paper version of this document, we show that there are no equilibrium left-tailed disclosure policies that are not degenerate at 1 for any 1 [ 1 1]. 1 This fact, coupled with Proposition 1 establishes that, within the class of convex deterministic disclosure policies ( convex meaning: disclosure policies for which if strategic managers of type disclose (resp., don t disclose) the earnings forecast 1 and also strategic managers of type 0 disclose (resp., don t disclose) the same earnings forecast 1,thenall strategic managers of type 00 ( 0 ) disclose (resp., don t disclose) 1 for all 1 ), the equilibrium disclosure policy described in Proposition 1 is unique. In the next section, we present some explicit numerical illustrations of the equilibrium for various parameterizations of the model, and we present a variety of comparative statics results. 5 Features of the Equilibrium To improve our understanding of the dependence of a manager s disclosure decision on both the probability he will behave strategically in the future and the manager s first period forecast, we next provide some (numerically derived) graphs of the equilibrium period 1 disclosure policy. In all of these graphs, we assume [0 1] and e 1 [ 1 1]. Each of Figures and 3 below shows the partition of ( 1 )-space into disclosure and no disclosure regions. Both figures show, consistent with Proposition 1, that for each [0 1], thereisacutoff 1 () such that a manager who is strategic in the first period and who will behave strategically in the second period with probability issues a forecast if 1 1 () but does not issue a forecast if 1 1 (). Thefigures also show that the cutoff function 1 () is weakly decreasing in the probability, indicating that strategic managers are more likely to issue a forecast in the first period the more likely they are to behave strategically in the second period. The figures also illustrate that managers with probability = 75 of being strategic only disclose forecasts that increase their first period price, i.e., if the forecast is such that the disclosure price (1 + 1 ) 1 exceeds the no disclosure price 1 ( 1 ). Figure is based on the parameters =0 and =075. For these parameter values, even strategic managers in period 1 who have a high probability of behaving strategically in period do not disclose very low values of 1. In this example, and consistent with Proposition 1, the first period disclosure threshold is given by 1 () = 1( 1 )+ 1 () 1+ 1 for all = 75. Figure 3 exhibits another partition of ( 1 )-space into disclosure and no disclosure regions for =160 and =075. For the latter parameter values, the manager places greater value on developing a reputation than for the parameter values underlying Figure. Also, for the parameter values corresponding to Figure 3, the number 0 b 1 described as in the statement of Proposition 1 is such that all strategic 1 A left-tailed disclosure policy is defined analogously to a right-tailed policy: if a manager with probability of being strategic in period prefers to disclose 1,thensodoallmanagerswhoseprobabilityofbeingstrategicinperiodis 0 Also, a disclosure policy is said to be non-degenerate at 1 if there are some managers that prefer to disclose 1 and some who don t. 16

18 1.0 x 1 x c 1t 0.5 Disclosure P 1 (nd 1 ) 1+k t No disclosure t ^t=1 Figure : Partition of the ( 1 )-space into a no-disclosure and a disclosure region for the parameter values =0, =075 managers in period 1 who anticipate behaving strategically in period with probability b disclose even the worst information 1 = 1 they could possibly receive in the first period. Disclosing these most unfavorable forecasts in the first period substantially enhances the manager s reputation for being forthcoming in the second period and, as a consequence, also substantially increases the firm s stock price in the second period when the manager does not issue a forecast in the second period. Adopting such expansive first period disclosures also increases the firm s first period no disclosure price because such a policy leads investors to believe that the absence of disclosures is indicative of the manager not having received information, rather than having withheld information, in the first period. Corollary 1 combines the results of these figures with the observation that the disclosure of the lowest possible outcome can never happen when managers do not have reputation concerns, as is the case in the second period of this model or in all single period models. Corollary 1 A manager who behaves strategically in the first period might optimally disclose the lowest possible outcome, 1 = 1. A manager who behaves strategically in the second period never discloses the lowest possible outcome. That is, for all, 1,and 1, 1 1 () 0; (8) ( 1 1 ) 1 1 (9) (Note the weak inequality in LHS(8), and the strict inequality in LHS(9).) The substance of this corollary is that reputation-related concerns in multi-period settings can overturn the reluctance that strategic managers 17

19 1.0 x 1 x c 1t 0.5 Disclosure P 1 (nd 1 ) 1+k t No disclosure 1.0 t ^t Figure 3: Partition of the ( 1 )-space into a no-disclosure and a disclosure region for the parameter values =160, =075 otherwise have in single period settings to issue a very negative forecast. Corollary continues to explore the connections between the incentives of strategic managers to issue a forecast in single period settings to their incentives to issue a forecast in multi-period settings when reputational considerations are present. In this corollary, as in the discussion following Proposition 1, we say that a manager does, or does not, manage his reputation depending on whether the cutoff 1 defining his first period disclosure policy is below, or equal to, the scaled first period no disclosure price 1(1) Corollary () There are always some strategic managers in period 1 who manage their reputations. Which managers manage their reputation is determined by the threshold + definedinproposition1(1): () all strategic managers with manage their reputation; () no strategic manager with manages his reputation: 1 () = 1(1) 1+ 1 for all ; () The average type of manager, =, does not manage his reputation, i.e.,. The corollary follows directly from Proposition 1 part 1. determines which managers manage their reputations: the managers who do are the managers who have a sufficiently high probability of being strategic in the future. Managers who have a lower probability of being strategic in the future do not manage their reputations, because they won t get a high enough return from doing so. The reduction in the price they receive today as a consequence of disclosing unfavorable information is not offset by the increased price they expect to get in the future in the event they do not issue a forecast in the future. Other motivations for managers to disclose bad news have been discussed in the literature. For instance, Skinner (1994) and (1997) provides evidence that the threat of lawsuits arising from large negative earnings surprises induces managers to pre-announce earnings in order to reduce litiation costs. 18

20 Part () of this corollary also establishes the following robustness properties of the equilibrium: managers who are strategic in the first period and are strategic in the second period with probability less than or equal to all adopt the same first period disclosure policy. Specifically, they all disclose the first period earnings forecast 1 (when received) iff the following inequality holds: (1 + 1 ) 1 1 ( 1 ) All these managers do not manage their reputation; they choose the same first period disclosure policy they would have chosen had they faced a one period disclosure problem and reputational considerations were absent. Moreover, since by part () of the corollary (and is the median of the uniformly distributed random variable ), it follows that more than 50% of all managers adopt the same first period disclosure policy. The source of this robustness was mentioned in the Introduction: if investors were to believe that all strategic managers will issue a particular low first period forecast, investors will not update their beliefs about a given manager s reputation for being forthcoming upon observing a manager disclose that low forecast. 3 That failure of investors to update their beliefs induces strategic managers not to follow through and issue that low forecast when they receive it, which implies that investors cannot hold such beliefs (about what all strategic managers will disclose) in equilibrium. In short, in equilibrium, issuing a particular low forecast can improve a manager s reputation for being forthcoming only when most strategic managers do not issue that particular low forecast to manage their reputation. With further parameterization of the model, these last two results can be further sharpened: when [0 1] and e 1 [ 1 1], itcanbeshownthat = 75, thatis,75% of all managers adopt the same first period disclosure policy, and that disclosure policy entails that none of the managers manage their reputations. 4 3 To see why this happens formally, suppose investors believe that every type of manager would disclose some particular unfavorable forecast in the period he received that forecast. Then, using Bayes rule, investors s posterior beliefs that a manager is of type, given the manager disclosed, is: Pr( is disclosed )() Pr( = is disclosed)= Pr( is disclosed 0 )( 0 ) 0 By assumption, Pr( is disclosed ) = for all types of managers, so Pr( = is disclosed)= () ( 0 ) 0 = () So, investors posteriors beliefs and investors prior beliefs about managers types coincide; that is, observation of the disclosure of the unfavorable forecast does not cause investors to revise their beliefs about the manager s type. 4 To see this: recall that is that unique that solves ( 3)+( +)( ) =0. When [0 1], = = 1 and hence solves 3 =0 Hence, =075. When = = 75 (where managers with withhold information and managers with disclose it), investors expectation of conditional on a forecast being issued and their expectation of conditional on no forecast being issued are the same and both equal to the prior expectation = 1. If = 75, investors perceive the manager to be more likely to be forthcoming (i.e., have a lower type ) if he issued a forecast than if he didn t issue a forecast in the first period. Investors revise their beliefs about the manager being forthcoming upwards following a forecast because investors attribute the forecast issued to the manager being (likely) constrained/forthcoming. If were less than = 75, the inequality would reverse: investors would perceive the manager to be more likely to be strategic (i.e., have a higher type ) if he issued a forecast than if he didn t issue a forecast in the first period. Investors would revise their 19