Faceless trading in a secondary stock market not only redistributes wealth among investors but also generates information that feeds back to real decisions. Using this observation we re‐evaluate the “leveling‐the‐playing‐field” rationale for disclosure to secondary stock markets. By partially preempting traders' information advantage established from information acquisition, disclosure reduces private incentives to acquire information, resulting in two opposite effects on firm value. On one hand, this narrows the information gap between informed and uninformed traders and improves liquidity of firm shares. On the other hand, this reduces the informational feedback from the stock market to real decisions. This tradeoff determines the optimal disclosure policy. The model explains why firm value can be higher in an environment that simultaneously promotes disclosure and private information production and why growth firms are endogenously more opaque than value firms.

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Abstract:In this paper, we model earnings management as a consequence of the interaction among self-interested economic agents, namely the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show various economic trade-offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings management activity produces accounting reports that deviate from what is prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and Sshaped, recognizing the manager's reporting incentives. We also explore policy implications, noting (i) the regulator may find enforcing a zero-tolerance policy -no earnings management is allowed -economically undesirable; and (ii) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude earnings management is better understood in a strategic context involving various economic trade-offs.

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