The Value of Confession: Admitting Mistakes to Build Reputation

Abstract

Often firms reveal oversights and bad decisions publicly through their financial reporting (for instance, restating earnings, impairing goodwill, etc.). These "confessions," which usually lead to immediate reputation losses, may be attributed to attempts to be perceived as transparent or to attempts to avoid likely litigation costs. In this paper, however, we argue that reputational concerns about perceived ability alone can provide firms with strong enough incentives to confess their mistakes, even in the absence of other non-reputational disciplinary mechanisms. Analyzing the repeated interaction between a firm and an external evaluator who may detect the firm's mistakes, we show that in equilibrium a confession places the firm under higher future scrutiny, which is more costly for lower quality firms. Consequently, in equilibrium, higher quality firms confess mistakes more often.

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