To Believe or Not to Believe

Abstract

This paper explains how the actions of skeptical traders can make manipulable earnings reports informative. Our model consists of a price-maximizing manager who chooses a cheap talk report, a profit-maximizing trader who may then seek costly information, and competitive market makers. Since the manager can influence the trader's information acquisition decision, the manager may choose to reveal even bad news to decrease the impact of order flows on prices. The paper provides foundations for treating positive and negative earnings surprises as good news and bad news respectively, even when external auditing cannot constrain opportunistic managers. Testable implications are derived.

Keywords: Cheap talk; Earnings disclosure, Market microstructure

JEL Classification: G14, G10, M40