Journal of Financial Reporting, Forthcoming
45 Pages Posted: 11 Mar 2015 Last revised: 5 Sep 2015
Date Written: September 4, 2015
We extend the CAPM to a setting where a firm reports earnings prior to selling shares to investors. We show that an entrepreneur, as representative of a firm's initial owners, will choose to report earnings that asymmetrically reflect future cash flow. In modeling the entrepreneur's reporting choice, we deliberately abstract away from the stewardship role of accounting. In our model, the sole purpose of reported earnings is to facilitate valuation by the firm's equity investors. Nevertheless, we show that a firm's earnings will reflect future cash flow to a greater (lesser) extent in bad states (good states) –– when that cash flow is anticipated to be low (high). Importantly, we also show that the asymmetry in reporting generates asymmetry in the firm's systematic risk. When a firm's earnings reflect future cash flow to a greater extent in bad states, the firm's covariance with the market portfolio will be lower in bad states.
Keywords: asymmetric reporting; reporting precision; the CAPM; Beta; systematic risk; cost of capital
JEL Classification: G11, G12, G14, G31
Suggested Citation: Suggested Citation