Asymmetric Reporting

Journal of Financial Reporting, Forthcoming

45 Pages Posted: 11 Mar 2015 Last revised: 5 Sep 2015

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Daniel J. Taylor

Wharton School, University of Pennsylvania

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: September 4, 2015

Abstract

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

Armstrong, Chris S. and Taylor, Daniel and Verrecchia, Robert E., Asymmetric Reporting (September 4, 2015). Journal of Financial Reporting, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2575906 or http://dx.doi.org/10.2139/ssrn.2575906

Chris S. Armstrong

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Daniel Taylor (Contact Author)

Wharton School, University of Pennsylvania ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Robert E. Verrecchia

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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