Financial Reporting and Moral Sentiments

Radhika Lunawat is Assistant Professor of Accounting and Economics at the University of California-Irvine Paul Merage School of Business; Timothy W. Shields is Associate Professor of Accounting at Chapman University and the Economic Science Institute; and Gregory Waymire is Asa Griggs Candler Professor of Accounting at Emory University Goizueta Business School and the Economic Science Institute. This post is based on their recent paper, forthcoming in the Journal of Accounting & Economics.

Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants.

—Louis Brandeis (1914, 92)

We experimentally evaluate whether financial reporting has economic value in a sparse setting where contracting is not possible. We hypothesize that financial reporting leads a manager to alter her behavior in anticipation of an investor’s evaluation of the manager’s conduct, as revealed by financial reporting. The desire to be viewed positively by others will lead the manager to take actions that benefit investors.

Our experimental predictions derive from the hypothesis that people desire to take altruistic actions and to be seen doing so. We define a moral sentiment as a feeling (both emotional and cognitive) that another person is intentionally benefited or harmed by an action that serves to determine the propriety of that action. Moral sentiments develop because an actor believes that an altruistic action is inherently satisfying regardless of whether anyone discovers that the action was taken. Furthermore, they will be viewed positively by others if they learn of the action taken.

We test the hypothesis using an experiment. Our experiment uses a six-period Reinvestment Game. After every period except the final one, the manager divides earnings between an investor dividend, self-compensation, and reinvestment of remaining resources to increase future earnings. After the final period, the manager divides the remaining resources (i.e., cumulative earnings net of prior dividends and compensation) between the investor and herself. The finite-period Reinvestment Game is like a corporation in that an investor’s initial investment provides “seed capital” required for the firm to operate, but reinvestment allows managerial power over firm resources to grow relative to investors’ power.

We manipulate the availability of a financial report at the end of each period that communicates earnings and resources free from bias and noise. The investor can observe this information but cannot directly impose a sanction if the manager acts contrary to the investor’s interests.

We predict that that financial reporting has two effects on managerial actions. First, because reporting reveals the manager’s final resource allocation in relation to the wealth available, the manager can expect the investor to judge unambiguously whether the manager’s choice was generous or selfish. When reporting is present, the manager will pay a higher final distribution to the investor, controlling for past dividends and salaries. Second, financial reporting makes interim reinvestment observable and subject to the investor’s moral evaluation. When reporting is present, the manager is more likely to avoid interim dividend payments and personal compensation to reinvest funds and obtain higher future earnings. We find strong evidence supporting both predicted effects: other things being equal, managers pay higher final distributions and reinvest larger amounts when financial reporting is present.

The broader meaning of our findings is that financial reporting, at least within the context of our experiment, can have economic value even when opportunities for contracting through ex-post sanctions are not feasible. Our findings provide support for the long-standing view that financial reporting provides “sunlight” that renders managerial behavior transparent and leads to more virtuous managerial conduct. These findings suggest a more profound role for financial reporting linked to the moral underpinnings of trust within modern economies.

The complete paper is available for download here.

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