Reporting Discretion and Private Information Communication Through Earnings

Posted: 30 Apr 2001

See all articles by Mandira Roy Sankar

Mandira Roy Sankar

University of Southern California - Leventhal School of Accounting

K.R. Subramanyam

University of Southern California - Leventhal School of Accounting

Abstract

We model a two-period pure exchange economy where a risk averse manager, who has private information regarding future earnings, is required to issue an earnings report to investors at the end of each period. While the manager is prohibited from directly disclosing her private information, she is allowed to bias reported earnings in the first period, subject to GAAP rules that require that a specified proportion of the bias be reversed subsequently. We show there is a minimum threshold of reversal, such that, when the proportion of required reversal is above this threshold, the manager smooths income and communicates her private information through reported earnings. Consequently, the market attaches greater weight to reported earnings than under a regime that allows no discretion. When the required reversal is below the minimum threshold, the manager increases reported earnings without limit and the equilibrium degenerates. When the manager is not endowed with any private information, the market unravels the "true" earnings and price is unaffected by earnings management. Our results underscore the importance of both allowing and restricting reporting discretion through formal mechanisms.

JEL Classification: M41, M43, M44

Suggested Citation

Sankar, Mandira Roy and Subramanyam, K.R., Reporting Discretion and Private Information Communication Through Earnings. Journal of Accounting Research, August 2001. Available at SSRN: https://ssrn.com/abstract=268340

Mandira Roy Sankar

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-1846 (Phone)
213-747-2815 (Fax)

K.R. Subramanyam (Contact Author)

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-5017 (Phone)
213-747-2815 (Fax)

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