Financial Misreporting: Hiding in the Shadows or in Plain Sight?
53 Pages Posted: 23 Apr 2018 Last revised: 14 Jan 2019
Date Written: December 1, 2018
This paper examines how the ex ante level of public scrutiny influences a manager’s subsequent decision to misreport. The conventional wisdom is that high levels of public scrutiny facilitate monitoring and increase the cost of misreporting, suggesting a negative relation between scrutiny and misreporting. However, public scrutiny also increases the weight that investors place on earnings in valuing the firm. This in turn increases the benefit of misreporting, suggesting a positive relation. We formalize these two countervailing forces––“monitoring” and “valuation”––in the context of a parsimonious model of misreporting. We show that the combination of these two forces leads to a unimodal relation. Specifically, as the level of public scrutiny increases, misreporting first increases, reaches an inflection point, and then decreases. We find evidence of such a relation in multiple empirical measures of misreporting and multiple measures of public scrutiny.
Keywords: misreporting, misrepresentation, fraud, earnings management, monitoring, valuation, information quality, information environment
JEL Classification: G14, G34, L21, M41, M42, M43
Suggested Citation: Suggested Citation