The Credibility of Financial Reporting: A Reputation-Based Approach

40 Pages Posted: 26 Jan 2017 Last revised: 2 Feb 2017

See all articles by Ivan Marinovic

Ivan Marinovic

Graduate School of Business, Stanford University

Ying Liang

CUNY Baruch College; City University of New York

Felipe Varas

Duke University - Fuqua School of Business - Finance Department

Date Written: January 26, 2017

Abstract

This paper studies the reliability of financial reporting when the credibility of the manager, represented by his misreporting propensity, is unknown. We show that credibility concerns affect the time-series of reported earnings, book values, and stock prices in ways that seem consistent with empirical evidence. When investors are uncertain about the credibility of the reporting process, earnings response coefficients as well as market-to-book values MTB are random and time-varying; relatively low MTB reflect poor credibility of financial reporting; stock prices are s-shaped in earnings surprises and relatively insensitive to bad news. Finally, when the manager is more likely to have reporting discretion, discretionary accruals tend to be larger and more volatile. We estimate the model using U.S. earnings announcement data during 2002-2012 and find that the probability of misreporting is 7%. A counterfactual analysis reveals that ignoring the possibility of misreporting leads to overestimation of the mean (3.5%), volatility (13%) and persistence of earnings (17%).

Keywords: dynamic cheap talk, reputation, credibility

JEL Classification: D82, D83, D84

Suggested Citation

Marinovic, Ivan and Liang, Ying and Varas, Felipe, The Credibility of Financial Reporting: A Reputation-Based Approach (January 26, 2017). Rock Center for Corporate Governance at Stanford University Working Paper No. 224; Stanford University Graduate School of Business Research Paper No. 17-10. Available at SSRN: https://ssrn.com/abstract=2906397 or http://dx.doi.org/10.2139/ssrn.2906397

Ivan Marinovic (Contact Author)

Graduate School of Business, Stanford University ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Ying Liang

CUNY Baruch College ( email )

17 Lexington Avenue
New York, NY 10021
United States

City University of New York ( email )

695 Park Avenue
New York, NY 10021
United States

Felipe Varas

Duke University - Fuqua School of Business - Finance Department ( email )

Durham, NC 27708-0120
United States

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