Financial Misreporting: Hiding in the Shadows or in Plain Sight?
52 Pages Posted: 23 Apr 2018
Date Written: April 2018
This paper examines how the quality of a firm’s information environment influences a manager’s subsequent decision to misreport. The conventional wisdom is that high-quality information facilitates monitoring and increases the cost of misreporting, suggesting a negative relation between the quality of the information environment and misreporting. However, high-quality information 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 quality of the information environment improves, misreporting first increases, reaches an inflection point, and then decreases. We find evidence of such a relation in multiple empirical measures of misreporting. Misreporting is greatest in a medium-quality environment and least in both high- and low-quality environments.
Keywords: misreporting, misrepresentation, fraud, earnings management, monitoring, valuation, information quality, information environment
JEL Classification: G14, G34, L21, M41, M42, M43
Suggested Citation: Suggested Citation