The Asymmetric Effect of Reporting Flexibility on Priced Risk

Abstract

Most firms covary more positively with downmarkets than upmarkets—a phenomenon I refer to as “risk asymmetry.” I predict and find that risk asymmetry is caused, at least in part, by a firm's ability to selectively obfuscate poor performance. Risk asymmetry decreases significantly when firms are required to adhere to the more stringent auditing standards mandated under Section 404 of the Sarbanes-Oxley Act, however this decrease is more muted for firms with weak internal controls. Consistent with my predictions, these patterns are stronger for more market-sensitive firms and weaker for firms that include relative performance evaluation in their CEOs' pay packages. Taken together with prior literature (which documents that risk asymmetry is priced), my results suggest that a firm can lower its cost of capital by credibly reducing its ability to obfuscate value-relevant information.

Keywords: reporting quality; obfuscation; asymmetric risk; Sarbanes-Oxley; internal controls

JEL Classification: G14, M41, M42, M49