The Value of Confession: Admitting Mistakes to Build Reputation

Abstract:     
Firms frequently admit mistakes voluntarily. For instance, they recall defective products and restate financial statements. These "confessions," which lead to immediate reputation losses, may be aimed at avoiding likely litigation costs. In this paper, however, we argue that long-term reputational concerns alone can provide firms with strong enough incentives to confess their mistakes, even in the absence of other disciplinary mechanisms. Analyzing a two-period interaction between an inspector and a firm, we show that in equilibrium a confession places the firm under higher future scrutiny, which is more costly for lower quality firms, and thus provides a means for higher quality firms to reveal their quality and build their long-term reputation.

Number of Pages in PDF File: 50

Keywords: reputation, restatement, recall, mistake, confession, admit, bad news, disclosure, inspector, inspection, verification

working papers series