Manipulation and Obfuscation of the Financial Report

Abstract

I model a signaling game of strategic reporting where the manager can bias and obfuscate the financial report in a market where investors only pay attention to randomly sampled parts of the financial report and then extrapolate the value of the firm based on this. The manager can inflate the stock price by obfuscating the financial report. This is done by disaggregating the report into a set of non-negative signals, capturing the profitability of different activities within the firm, whose mean is constrained to be equal to the reported profitability of the firm. Biasing the reported profitability increases the possible degree of obfuscation, incentivizing a larger bias, and causes mispricing if investors do not foresee the consequences of their extrapolative nature on the manager's reporting strategy. Even in the presence of extrapolative investors, the manager is never better off ex-ante by being able to bias, and if investors foresee the manager's strategic decisions, the bias will perfectly unravel and the manager's cost of biasing will be decreasing in investor sophistication whereas it is otherwise increasing.

Keywords: Extrapolation, Earnings Management, Price Efficiency, Financial Reporting, Bounded Rationality

JEL Classification: D82, D91, G14, G41, M41