Reporting Discretion and Feedback Effect

Abstract

Stock price often provides firms with new information, which can be used in the firms' subsequent real decisions. While prior studies focus on the ex-ante choice of disclosure in the presence of this feedback effect, we study how the feedback affects a myopic manager's incentive to bias the financial report after observing a private signal about the firm value. We also examine how such reporting discretions, allowed by accounting standards, affect the firm's price and value. We find that the manager overstates the accounting report more in the presence of feedback, but this bias brings forth on average both positive price and real effects for the firm. Intuitively, biasing the report encourages information production in the market because it leaves the speculator's privately acquired information more valuable for her trading. Her private information is revealed to the firm manager at the time of trading, and improves investment efficiency when used in the firm's subsequent investment decisions. However, the benefits due to feedback effect could disappear if there is a sufficiently high penalty associated with reporting bias for the firm.

Keywords: Feedback effect, misreporting, earnings management, real effects

JEL Classification: G3, M41